naked capitalism

I found this video by the Institute for New Economic Thinking, in which a number of prominent economists discussing the use of models, more than a bit frustrating, with Jamie Galbraith’s comments at the very end a notable exception.

Mainstream economics fetishizes the use of models. Even if your insight could be stated clearly and concisely in a narrative, it is not economics unless a model is involved. For instance, two of our colleagues have gone through Mankiw’s introductory economics textbook and have ascertained that every use of a graph is not only unnecessary, but in most cases serves to impede rather than add to the presentation of the concept under discussion.

The preoccupation with models suggests that the economics discipline has unduly limited its problem-solving abilities by giving high priority to “models”. Recall how central bankers rejected William White and Claudio Borio’s well documented warning that an international housing bubble was underway. The basis for the bankers’ dismissal? White and Borio had no theoretical underpinning for their view.

Similarly, you’ll hear Brad DeLong mention, and later distance himself from a prescription promulgated by Milton Friedman, and embraced by many in the profession, that all that mattered was that a model make good predictions. We discussed the so-called “F-twist” in ECONNED:

Friedman, like his peer Samuelson, played an important role in defining what constituted proper methodology. An oft-invoked section of an influential 1953 paper:

Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and in general, the more significant the theory, the more unrealistic the assumptions. . . . The reason is simple. A hypothesis is important if it “explains” much by little, that is, it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomenon to be explained and permits valid predictions on the basis of them alone. To be important, therefore, a hypothesis must be deceptively false in its assumptions; it takes account of, and accounts for, none of the many other attendant circumstances, since its very success shows them to be irrelevant for the phenomenon to be explained.

To put the point less paradoxically, the relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose at hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.

Friedman’s statement that “unrealistic assumptions” often prove the best is willfully false. In the absence of any evidence to the contrary, unrealistic assumptions are worse than realistic ones. An “unrealistic” assumption is one directly contradicted by present evidence. This amounts to a “get out of reality free” card.

The deceptive aspect of this argument is the slippery word “unrealistic.” Now it is true that relaxing the known parameters of a situation can be very productive. In his paper, Friedman uses the example of how the “law” in physics that describes how bodies fall assumes a vacuum, which is an unrealistic assumption, at least on planet Earth. Similarly, a line in geometry has no thickness, again a condition never observed in real life.

But in this context, the vacuum is not an “unrealistic assumption” but an abstraction that eliminates a known condition, air resistance. It is not a feature grafted on to make a construct tidy, but the stripping away of an environmental element to see if getting rid of it exposes an underlying, durable pattern. This procedure is in keeping with how mathematics as a discipline evolved, through the successive whittling away of extraneous elements.

But in economics, core and oft-used assumptions necessary to make many theories work, such as “everyone has perfect information,” are unrealistic not in the sense of stripping out real-world aspects that are noisy, but in adding properties that are not observed or even well-approximated in reality. Yet they are deemed valid and those who protest are referred to Friedman. Economists may argue that that isn’t the case, that the “perfect information” assumption simply serves to eliminate the role of bad information in decisions. But the sort of all-encompassing knowledge often posited to make a model work goes well beyond that. Similarly, “rational” economic actors are super-beings with cognitive and computational capabilities beyond those of the best computers, capable of weighing all that perfect information.

Friedman and his followers have a ready defense. The assumptions don’t matter; all that counts is that the theory “works.” Even though Samuelson wrote a harsh criticism of Friedman’s “unrealistic” assumptions, both wanted economics to be “scientific.” The sort of science they had in mind was what philosophers call “instrumentalist,” which judges a theory by its predictive power alone…

But it is actually difficult to prove anything conclusively in economics. In fact, some fundamental constructs are taken on what amounts to faith.

Models, or any abstraction, is a way of whittling down reality to the point that we can get our limited brains around it. There is more than a touch of hubris in the way economists celebrate a compensation mechanism for our constrained cognitive capabilities.

Readers gave high marks to Andrew Dittmer’s summary of a dense but very important paper by Claudio Borio and Piti Disyatat of the BIS and asked if he could produce more of the same.

While Andrew, a recent PhD in mathematics, has assigned himself some truly unpleasant tasks, like reading every bank lobbying document he could get his hands on to see what their defenses of their privileged role amounted to, he has yet to produce any output from these endeavors that are ready for public consumption.

However, I thought readers might enjoy one of Andrew’s older works. He e-mailed me right after I started working on ECONNED. Our conversation went something like this:

Andrew: I am a Ph.D. student in mathematics at Harvard. I have found your blog to be terribly interesting while trying to make sense of the way in which the global economic architecture is evolving, or devolving as the case may be.

I should finish my doctorate in a month, assuming nothing goes terribly wrong. I would be very happy to help you with your book in whatever ways are useful for you. In particular, I would definitely be able to review and comment in a fairly minute and exacting way on chapters of your book.

Me: That is a very kind offer, thanks! What is your dissertation on, BTW? And are you doing theoretical or applied math?

Andrew: Theoretical math

Me: [inwardly] Holy shit, this is one of the smartest people in the country!

It turns out that Andrew did indeed provide detailed commentary on the logic of all the chapters, as well as the thread of the argument across the book after it was drafted (something few editors do). Chapter 2 was the most daunting chapter, in that it is a fundamental critique of economics from a methodological standpoint. Every time I though I had a draft nailed, I’d get extensive feedback from Steve Waldman and Andrew, with the net result that I’d go back and start from close to scratch. This happened eight times and I was clearly losing patience.

Andrew, recognizing that I was starting to lose it (writing an ambitious book in six months was rather deranged, and all the revisions were adding a lot of added pressure) suggested how to restructure the chapter in the form of a lesson guide for sixth graders (as mentioned earlier, Andrew taught six and seventh graders math in the Cambridge public schools on the side). It was useful and also provided some badly needed comic relief.

Those of you who have read ECONNED may recognize the parallels (I adopted his outline in large measure). I am confident readers who have not read the book will still enjoy his rendition.

* * * * * (HISTORY)

Once upon a time, about a hundred years ago, economics was different from how it is today. Many famous people had thought about economics, including Adam Smith, Ricardo, Marx, and others. Economics was not a perfect science, and lots of people who thought about economics disagreed. But in the last century, economists started to agree about two things: economics should become as mathematical as it possibly could, and politicians should listen to economists.

Economics at the time was not a very mathematical science, at least compared to the way it is today. Economists used to write articles with very few equations, or even without any equations at all. When did economists start to use math more? The beginnings might have been toward the end of the 1800′s, with some economists named Jevons, Menger, and Walras. But a person who was particularly important was Paul Samuelson. He comes into the story later.

In the 1920′s and 1930′s, there lived a great economist named John Maynard Keynes who came up with new ideas about economics. Many people thought that they made a lot of sense because they seemed to explain how governments had managed to get their countries out of the Great Depression. Politicians began to listen to economists more and more.

Someone named Lorie Tarshis went to Keynes’ classes, took notes, and made a book out of it. The name of the book was “Elements of Economics.” It was published in 1947. Back then, there were people who thought that communist spies were everywhere. Some of these people, including William F. Buckley, decided that Tarshis’ book was also part of a communist plot, and started saying so very loudly to as many people as they could find. Many colleges became afraid to use “Elements of Economics” as a textbook.

Meanwhile, Paul Samuelson was writing his dissertation, and he saw how angry the people had gotten with Tarshis. He decided to make it so his dissertation could not be attacked in the same way. So he did three things, writing very “carefully and lawyer like.” First, he changed Keynes’ ideas a little bit so that in Samuelson’s version of them, they said that corporations in the capitalist system would always give everybody a job as long as the government and labor unions didn’t bother the corporations. That made corporations happy with him, so that they didn’t think people should call him a communist. Second, he called his ideas “neoclassical synthesis Keynesianism.” That made other economists think that he wasn’t changing their ideas very much, so they were more happy to support him. Third, he wrote all of his arguments up in mathematical form. Now why would he want to write up his ideas as mathematical arguments?

Well, for one thing, a lot of people don’t understand complicated math, so he could automatically win arguments with someone who didn’t understand math. Even the people who went around calling people communists couldn’t call him a communist if they didn’t understand the math he was doing. There was another reason, too. Samuelson could turn problems that economists used to argue about into equations. Then he would solve the equations and the argument would be over. [Lucas quote]

Samuelson’s book was called “Foundations of Economic Analysis.” It was published in 1947, and it became a big success. Nobody told Samuelson that he was a communist. Other economists started to use mathematical models more.

Later on, in the 1950′s, two economists named Arrow and Debreu made a simplified mathematical model of the economy, and proved that in their model, there would never be a time when people wanted to buy something and nobody would sell it to them. Economists thought that this was very exciting. Now they used math even more.

Nowadays, most papers on economics have equations in them. All economists have to be able to talk about their ideas using mathematical models and statistics, or other economists won’t respect them. This is part of what is called being able to “think like an economist.” It is a special ability that you can only learn by going to graduate school in economics. A professor named David Colander surveyed economics graduate students to find out which of seven factors were most important in order for them to succeed in graduate school. The top three factors all had to do with being good at math. The least important factor was having “a thorough knowledge of the economy.”

So learning how to “think like an economist” is very important, because if you don’t do it, then no matter how well you understand the actual economy, economists still won’t take your arguments seriously.

Have these changes made economics a better science, or a worse science?

* * * * * (CRITICISM OF AXIOMATIC MODELS)

Samuelson, by using mathematics, was able to win arguments and make sure people liked him, especially the more important people. Other economists followed his example. How did Samuelson use mathematics to become successful? The first thing he did, if you remember, was that he made sure that his economics would say that corporations would make sure people had jobs, and so corporations were good. So his first technique was to make sure that his economics said things that people would like. But that doesn’t seem to make sense. Isn’t the point of mathematics that in math, things are either right or wrong?

Actually, the way that things work in math is that first, you make ASSUMPTIONS, and then you figure out from the assumptions whether things are right or wrong. So the way that you use a mathematical argument to say things that people will like is that you change the assumptions until they make it so the answers are answers that people like.

[At this point the kids become angry. "That's stupid, " they say. "It sounds like they're going in circles." The responsible teacher at this point tries to avoid being too political with his or her young audience, and tries to make vague excuses for the economists. However, the teacher can't help recognizing that the students sort of have a point.]

Even though economists were supposed to be using mathematics so that they wouldn’t have to argue any more, it doesn’t seem to help much if they can still get any answer they want by just changing their assumptions around. For example, [insert McCloskey quote about the A'/C'-theorem].

That means one way to figure out whether mainstream economics makes sense is to see what the assumptions are, and to try to decide whether those assumptions make sense. For example, what were Samuelson’s assumptions? What were Arrow and Debreu’s assumptions?

Samuelson had one big assumption, that economists call ergodicity.

[Teacher pauses to give kids time to stumble over the word.]

When they say ergodicity, they mean that no matter what happens in the world, in the end, everything will reach a point whether things stop changing. That point is called the “equilibrium.” At the equilibrium, everyone will end up with a certain amount of money. The amount of money that everybody gets at the equilibrium depends on how talented they are, and not on anything that happened before. So if you rob a bank, it won’t matter because when you get to the equilibrium, if you’re stupid, you will still have the same amount of money you would have had if you didn’t rob the bank.

[A kid with disciplinary issues mutters, "This is bullshit. Why do we have to learn this?" Other kids ignore him and try to take notes.]

What’s more, at the equilibrium point, everyone will have a job, everyone will have lots of stuff, and no one will feel like there is any way that America could be a better country.

[Eyes glaze over.]

Actually, what’s kind of funny is that in physics, if there are three stars or planets and gravity pulls them around, what do you think happens? They end up going into orbits around each other. But their orbits will be different if they start out in different places. So it would be kind of weird if an economy with millions of people doing all sorts of complicated things always ended up in the same way, if three planets can end up in all sorts of different ways depending on where they start moving from. But who knows? Maybe the economists are right about ergodicity.

It’s actually even weirder than that. Because in physics, Poincaré figured out one hundred years ago that even if you know where the planets start out, if you’re wrong about how far apart two planets are by even an inch, then as time goes on, the orbits that you think the planets will go on will start to get more and more wrong, until there comes a point when the orbits you thought the planets were going to settle on are totally different from the way that the planets are actually traveling. So it’s really hard to predict what will happen even to three planets, if you try to look far enough into the future. But who knows? Maybe economists are right about ergodicity, and in an economy if you measure things carefully enough and are clever enough, you can figure out exactly what will happen to the economy for the next one hundred years.

Then there were Arrow and Debreu, who proved that in their model people who wanted to buy something would always be able to find someone who would sell it to them. They had assumptions, too. They assumed ergodicity, like Samuelson, but they also assumed other things. They assumed that everybody in the world knows everything about everything that is being sold all over the world. Also that you know the odds of whether it will rain on a Tuesday in a thousand years. This is called “perfect information.”

Some people who don’t think like economists have made fun of economists for making unrealistic assumptions like these. Those people seem to think that if economics is based on assumptions like these, that maybe aren’t true, then economics must not be a useful science. But these people don’t know that in 1953, Milton Friedman destroyed all of their arguments with a magical “get-out-of-reality-free card.” When you play this card, it makes it so you’re not allowed to make fun of economists for basing their theories on assumptions that aren’t true.

Friedman said that if you could use a theory to describe the world correctly, it didn’t matter if your assumptions weren’t true. Actually, it was even better if they weren’t true, because that would mean that your theory was very, very clever!

That means to decide if standard economics makes sense, we need to see whether it says things that are true, and we shouldn’t pay attention to whether or not the assumptions are true. For example, economists say it’s bad to pay the people with the worst jobs more money

[Kids snap out of their stupor. "What?" a kid asks, dazed.]

because if you do, then the people who give the poor people jobs will fire some of them. A couple of economists named Card and Krueger tried to test the theory and they announced that the theory was wrong, and you could pay poor people more money and have it be a good thing. Other economists saw that if Card and Krueger were right, then standard economics had to be wrong, and they went into shock. They were sure that Card and Krueger had to be wrong somehow.

[One kid asks, "But wait. I thought that Friedman said that the assumptions of the theory weren't important, just whether it was true in real life. If it wasn't true in real life, then it was a bad theory, right?" Teacher tells the kid to wait, there isn't much time left in class and there are a lot of other things left to discuss.]

Some of them tested what happened when you gave poor people more money and said that no, the theory was right after all. Other ones tested it too and said that Card and Krueger were right and the other economists were wrong. So even though Friedman’s magic get-out-of-reality-free card sounds like a cool thing, it’s actually really hard for economists to use it in real life.

But even though the card might not really work, mostly people don’t argue with economists and so they still use their theories and “think like economists.” “Thinking like economists” is kind of like looking at the world with 3-D glasses. When you’re watching a 3-D movie, it makes it so that you see really neat things. When you’re not watching a 3-D movie, then everything looks red and blue and kind of weird. But economists still like wearing their 3-D glasses.

When economists look at the world through their 3-D glasses, they see it as having “ergodicity.” Remember what that means? It means that if you just leave corporations alone and help them to do what they want faster, the world will, all by itself, become a happy place. You don’t need to stop them from doing anything they want to do, or try to make them wear seatbelts. Just help them to drive as fast as possible. It also means that economists can figure out what the economy is going to do, and you can trust them.

For example, economists have invented computer programs called “DSGE models” that they use to predict the future. Because of ergodicity, the DSGE models say that nothing bad will happen to the economy unless something crazy happens, like the people in the Middle East not wanting to sell us any more oil or Martians attacking the earth.

Another example is that some of the big banks invented really complicated things that were sort of like money, but sort of not like money. Those things are called “derivatives.” The big banks liked the derivatives because they were sure they could make a lot of real money from them. Some other people who weren’t economists thought that derivatives might be dangerous. Those people thought that if things in the economy went faster, they might also break more easily. But because of ergodicity, economists were sure that since derivatives helped corporations do things that they want to do faster, the derivatives would be good. So the economists made it so nobody paid attention to the people who said derivatives were dangerous, and the big banks got to make all of the derivatives they wanted to.

Later, the derivatives helped to make trouble in the economy. That’s why some of your parents lost their jobs. The big banks who made all the money from the derivatives had trouble too and were almost destroyed, but the government gave them more money so that nothing bad would happen to them. Meanwhile, the government won’t let people find out what it did with the money it gave to the banks. It says that the details need to be kept secret by a group of bankers and economists called the Federal Reserve. The people on the Federal Reserve think like economists and so it’s okay for them to know the secret.

* * * * * (OTHER APPROACHES TO ECONOMICS)

There have been some people who don’t like the economics that starts with assumptions and then tries to do math with the assumptions. [you could cite Blaug here] Some of these people have tried to make other kinds of economics.

Some people tried to make a kind of economics that is called “systems dynamics.” In this economics, you pretend like the economy is a really big machine, and sometimes parts of it can go crazy or break. Some people liked this kind of economics, including some of the people who said that derivatives were dangerous. But economists mostly don’t like this kind of economics, so they don’t use it.

One day, some economists noticed that if you’re playing cards, if you peek at someone else’s hand, then you’ll probably win more than someone who doesn’t peek. That’s because you know your cards and their cards and they only know their own cards. The economists who noticed this called it “asymmetric information.” Since economists before that assumed “perfect information,” so everybody playing cards knows everybody else’s cards, they were amazed at how smart these economists were and gave them Nobel Prizes.

Another day, some economists noticed that sometimes people are stupid and do things that waste money. They made a theory about this called “behavioral economics.” Since economists before that assumed “perfect information,” [and rational expectations] or in other words, people know everything that is happening everywhere in the world and always do whatever makes the most money, they were amazed at how smart these economists were and gave them Nobel Prizes.

There were also some economists who noticed that if you give another kid your lunch and tell him to hold it for you until lunch, he might eat your chocolate bar and then tell you that someone stole it. Their theory is called the “principal/agent dilemma.” This theory also seemed very new and exciting to other economists.

When people started making fun of economics because economists hadn’t realized that there was going to be an economic crisis, some economists like Eichengreen and Rodrik told those people that they were wrong and economists could have been able to know that there was going to be a crisis. Eichengreen and Rodrik said that the only problem was that economists hadn’t used the new theories like asymmetric information, behavioral economics, and principal/agent theory, but economists would remember and use them next time.

But since all of the new theories are different from the old economics, what usually happens is that economists use only one of them at a time. If they got rid of the old economics completely, then other economists who like the old economics would be angry at them or not pay attention to them. So they use the old economics and then add on a little bit of the new economics and hope that it works. An economist named Peter Dorman said that if the old economics is like a big giant, then each thing that is wrong about the old economics is like a wound that blood is pouring out of. Each new kind of economics is like a band-aid that economists try to put on one of the wounds, but they can’t put band-aids on all of the wounds at the same time. So the giant lumbers forward, blood spurts out of him all over the place, and nothing changes. Gruesome, huh?

Some economists have tried to use a lot less theories and mostly just figure out what is actually going on in the world. This kind of economics is called “empirical research.” For example, when Card and Krueger tried to figure out what would happen if you paid more money to people with crappy jobs, that was empirical research.

But when they did it, a whole lot of people got angry with them and disagreed. So it can end up being pretty hard to tell what is going on in the world.

There are a few reasons why this is true. For one thing, the way economists usually try to find out what is going on is by looking at some numbers or graphs and trying to find a pattern. But the numbers might not be right. And what happens if someone wants to study something and they can’t find any numbers to study it with? For example, some economics students decided they wanted to find out if the trouble with the economy had to do with making it so companies that try to get people to buy houses didn’t have to follow as many rules. But those companies wouldn’t give them any of the numbers they needed to find out if their idea was right. So the economics students gave up. They didn’t have to give up – they could have talked to people who bought houses and interviewed them and things like that. But it would have been more work and other economists might have thought that they were weird to use interviews instead of numbers. So instead they gave up.

This is kind of like the story about a drunk guy who loses his keys and walks over to the street light and looks under it. Somebody asks him why he’s looking under the light when he probably lost them some other place. He says that it’s dark in the other places so it’s hard to look there. Do you see the connection with the economics students who wanted to study houses? They couldn’t find the numbers that made it easy to look at their problem, so they stopped looking.

[In fact, the connection between the joke and the problems with the mortgage lender deregulation research is the one idea here that is abstract enough that it would be tricky to explain to sixth graders.]

Another problem is that if you look at enough graphs, you’ll eventually find one with a pattern just by chance. This is bad, because it might not be a real pattern. It might just be an accident. If you take a fake pattern and make people think that it’s a real pattern, that’s called “overfitting the data.” It’s kind of like cheating.

If you don’t want to cheat and overfit, there are some ways to make it more likely that you’re finding a real pattern and not a fake pattern. If you find a pattern one year, you can look at another year, or another place, and see if there is the same pattern. This is called “cross-validation.”

Even though it’s a good idea to do cross-validation, a lot of economists don’t do it. A couple of people named Gerber and Malhotra did detective work on economics papers, and they found out that lots of economists were probably overfitting. They couldn’t tell who was doing it, just that a lot of people were doing it. If you’re an economist, you want to have a good job, and to get a good job, it helps to find patterns and write papers describing the patterns to other people. So some economists maybe wanted to get a better job and so they overfitted so they could find more patterns.

* * * * * (STATUS AND FUTURE OF ECONOMICS)

Economics seems to be in a lot of trouble right now. The old economics has problems, and the new kinds of economics have problems too. Some economists have even given up studying the economy and now study things like speed-dating and violence in movies.

A guy named Thomas Kuhn said that when people make a science, they keep using it as long as they can. Sometimes they can tell the science isn’t working very well. This is called the “late-paradigm” stage. It sort of means that the old science has become sick. Even then, people will only stop using the old science when someone invents a new better science AND when all of the professors who liked the old science get old and die.

It looks like economics is in a “late-paradigm” stage. But people don’t have a new better economics, so people still keep using the old economics. What are some things that should happen?

(1) Economists should be honest about when they don’t know what will happen in the future so that people don’t rely on them in ways that they shouldn’t.
(2) Economists should admit that in economies some people want some things to happen and other people want other things to happen. They should be honest about what kind of world they want to live in, and not pretend like they know how to find a world in which everybody will be overjoyed.
(3) Economists should work less at trying to find reasons not to listen to people, and try harder to learn about the economy, even from theories that they don’t like, methods like interviews that don’t involve numbers, and from the ideas of people who are not economists.

Admittedly, my RSS reader is hardly a definitive check, but it does cover a pretty large number of financial and economics websites, including those of academics. And from what I can tell, an extremely important paper by Claudio Borio and Piti Disyatat of the BIS, “Global imbalances and the financial crisis: Link or no link?” has been relegated to the netherworld. The Economist’s blog (not the magazine) mentioned it in passing, and a VoxEU post on the article then led the WSJ economics blog to take notice. But from the major economics blogs and publications, silence.

Why would that be? One might surmise that this is a case of censorship. Borio has been a long-standing critic of the Greenspan and later Bernanke thesis that central banks should ignore asset and credit bubbles if prices are stable. He and William White went public (as public as you can go in the BIS) in 2003 with their contention that an international housing bubble was underway and action was warranted. Greenspan and virtually all other right-thinking economists ignored the bubble and other signs of trouble (like a sustained near zero consumer savings rate in the US) and drank the Great Moderation Kool-Aid instead.

Despite the overwhelming evidence of their colossal pre-crisis screw-up, most academic economists are unwilling to admit much if any error. And they are generally respectful towards Bernanke (the fact that the Fed is the biggest single source of funding for academic research no doubt contributes to the deference shown to the central bank).

The paper is important for a second reason: it seeks to address the limited and imprecise thinking about the relationship between the financial markets and the real economy. I cover some of this ground in ECONNED. The shortcomings of prevailing macro models include: an equilibrium assumption (by contrast, financial markets, which impact the real economy, have no propensity to equilibrium), no role for credit, banks, or even money (except sometimes in error terms).

In addition to its heretical views, another reason the Borio/Disyatat paper has gotten less attention than it warrants is that it is written densely and defensively, perhaps a response to the way the clear and well documented White/Borio papers on the housing bubble were dismissed as having no theoretical foundation. I read it early in the summer, and have dragged my feet in posting on it because it would be difficult to do it justice in a single piece. It should have occurred to me sooner to write about it over two or three posts.

However, I may simply not have been up to the task of making it accessible. Our Andrew Dittmer (a Harvard Phd in mathematics who among other things, has taught group theory to seventh graders) has converted the paper into Layspeak:

The May 2011 Bank of International Settlements paper by Claudio Borio and Piti
Disyatat is quite important It suffers, however, from one defect: it is not written in English, but in economese. I have therefore taken the liberty of poetically translating it into our language (and adding occasional remarks here and there). All numbers below are references to page numbers in the original paper.

* * * * *

The global financial crisis led to widespread dislocations and misery. However, another set of victims, hitherto overlooked, were central banking authorities and professors of economics who had staked their names on the thesis that the current configuration of the global financial system (which they had helped to engineer) was generally wonderful. These unfortunate souls were forced to come up with an explanation for the crisis on short notice, and it had to be an explanation in which they themselves played no role.

Ben Bernanke et al. rose brilliantly to the challenge. They remembered that many Asian countries had stocked up on foreign currency reserves in the hopes of never again being at the mercy of the IMF (26, note). Obviously, trying to resist the IMF was wrong and deserved criticism. Moreover, saying bad things about the Chinese would inevitably be welcomed in foreign policy circles eager to talk about the coming “bipolar confrontation” between America and China.

This “savings glut” theory argued that savings by Asian (and Middle Eastern) countries had washed like a tidal wave onto US financial markets, effectively forcing US money managers to invest imprudently in the course of their attempts to cope. For instance, these “excess savings” were widely assumed to have reduced long-term interest rates, thereby making credit cheaper.

There were some obvious problems with the global imbalances theory. Before the crisis exploded, many of the same economists had pointed to the same imbalances as a happy coincidence of needs, leading to better results for all (23). According to the sort of economic theory that was used in these explanations, if “global imbalances” were causing long-term interest rates to fall, that was simply a natural market outcome that should be contributing to equilibrium (23).

Consistency is the hobgoblin of little minds, and the “excess savings” theory was duly welcomed. It was even paid the supreme compliment of being accepted by Goldman Sachs’ lobbying division (see Effective Regulation, part 1, page 1).

Despite the consensus of these eminent authorities, we have decided to take a second look at the theory. Unfortunately, we have found further problems.

The idea of “national savings” or “current account surplus” refers to the total amount of exports sold minus the total amount of imports sold (more or less). The “excess savings” theory holds that this excess had to have been financed somehow, and so presumably by countries in surplus, like China.

However, for the US in 2010, the total amount of financial flows into the US was at least 60 times the current account deficit (9), counting only securities transactions. If this number were correct, then inflows would be 61 times the current account deficit, and outflows would be 60 times the current account deficit. The current account deficit is a drop in the bucket. Why would anyone assume it had anything to do with the picture at all?

Moreover, if the “savings glut” theory was correct, we would expect there to be certain historical correlations between the following variables: (a) current account deficits of the US, (b) US and world long-term interest rates, (c) value of the US dollar, (d) the global savings rate, (e) world GDP. There aren’t (4-6, see graphs).

You would also expect credit crises to occur mainly in countries with current account deficits. They don’t (6).

Suppose we look at a more reasonable variables: gross capital flows (13-14). What do we learn about the causes of the crisis?

Financial flows exploded from 1998 to 2007, expanding by a factor of four RELATIVE to world GDP (13), and then fell by 75% in 2008 (15). The most important source of financial flows was Europe, dwarfing the contributions of Asia and the Middle East (15). The bulk of inflows originated in the private sector (15).

If we look instead at foreign holdings of US securities (15-16), Europe is still dominant, but China and Japan are a little more prominent due to their large accumulations of foreign exchange reserves (15). Still, the Caribbean financial centers alone account for roughly the same proportion as either China or Japan (16). Other statistics provide a similar picture (17-19).

So what caused the crisis? Clearly, the shadow banking system (mainly based around US and European financial institutions) succeeding in generating huge amounts of leverage and financing all by itself (24, 28). Banks can expand credit independently of their reserve requirements (30) – the central bank’s role is limited to setting short-term interest rates (30). European banks deliberately levered themselves up so they could take advantage of
opportunities to use ABS in strategies (11), many of which were ultimately aimed at looting these same banks for the benefit of bank employees. These activities pushed long-term interest rates down. Short-term rates remained low because the Fed didn’t raise them as long as inflation didn’t appear to be an issue (25, 27).

The Asian countries played a small role as well. They didn’t want US/European-driven asset price inflation to spill over into distortions in their economies, and so they protected themselves by accumulating foreign exchange reserves (26 and 26 note). That was mean of them. If they had allowed more spillover, then the costs of the shadow banking system would have been partly borne by them, and that would have made the credit crisis less severe in the advanced countries (26). As things stand, instead, the advanced countries are suffering, while Asian countries have bounced back strongly (26).

What should we do? Well, we have suggestions for theory and practice. Let’s start with the practical suggestions.

Countries should do a better job of restraining their financial sectors (24). However, that will probably not be enough (24). Countries should also work together to share the burden of consequences of further crises (27). Unfortunately, countries are irrational and political and so are often unwilling to cooperate in ways we consider wise (27).

Since we can’t count on other countries doing the right thing, we will have to count on the Fed instead. If there is another boom in asset prices, the Fed should cool it off by raising interest rates and so inducing deflation in the rest of the economy. The balance of views in the international community has been shifting in this direction (27).

As for the theory, maybe you are wondering what was wrong with economics that led people to believe in the “savings glut” theory. We have a few ideas.

First, most present day macroeconomic analysis proceeds by imagining that people only trade physical objects with each other. They don’t use money, and they certainly don’t make loans or go bankrupt. Even though the people that make these analyses know that in the real world money and loans and bankruptcy DO exist, they think that is useful to pretend that they don’t and then arrive at authoritative conclusions. We would like to beg them humbly to reconsider this blind spot (2, 12, 21, 27-31).

Second, current analyses of interest rates make a distinction between the “market” interest rate and the “natural” interest rate. The distinction between these two rates is very subtle, so we’ll explain it carefully.

The “market” interest rate refers to the interest rates people pay on various kinds of loans. The “natural” interest rates is an unobservable variable that is equal to whatever economists decide the interest rate really ought to be for the purpose of some model. Usually, this imaginary interest rate is calculated in such a way that whatever the Fed and banks and hedge funds do, it can never change. It only depends on what physical goods are bought and sold in the economy (1-2, 20-23, 29).

In the past, economists have decided to use the imaginary interest rate instead of the actual interest rate. We don’t want to be disrespectful, but is there any chance they might be willing to change their minds?

Yves here. Blogger Sell on News echoes an argument made in ECONNED, namely, that “free markets” are a contradictory and incoherent construct, albeit from a different perspective. He also advocates another view near and dear to our heart, namely getting rid of economists (actually, that is overkill and will never happen. Keynes had it right: “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.”)

By Sell on News, a macro equities analyst . Cross posted from MacroBusiness

Probably the most wicked intellectual subterfuge of the last three decades — and goodness knows there have been many — has been the pretence that democracy and markets are two sides of the same coin. Both have been extolled under the banner of “liberty”. “Free markets” are somehow the hallmark of democracy and they should be allowed to roam free, untrammeled by evil governments who never doing anything right. Any number of commentators, coincidentally funded by right wing think tanks, warned us that constraining markets represents an attack on basic freedoms. Such elision is, of course, rubbish; and in many cases deliberate deceit. In a market one dollar equals one vote. The more money you have, the more votes you get. In a democracy it is one person, one vote. You can only be one person at a time (except in Florida, it seems). With this in mind, I was intrigued to see a response from Rob Windt mid week about the aftermath of the Icelandic bankruptcy:

What happened next was extraordinary. The belief that citizens had to pay for the mistakes of a financial monopoly, that an entire nation must be taxed to pay off private debts was shattered, transforming the relationship between citizens and their political institutions and eventually driving Iceland’s leaders to the side of their constituents.

The Head of State, Olafur Ragnar Grimsson, refused to ratify the law that would have made Iceland’s citizens responsible for its bankers’ debts, and accepted calls for a referendum.

This, I would suggest, is real liberty at work. And it is probably an early example of what I expect will become an increasingly political debate, rather than a managerialist debate, about the direction of developed economies. As Jeremy Grantham in his fine piece pointed out mid-week, there has been an unholy alliance between corporate profits and government spending, something he said he “never saw as a faint possibility”. It turns out that business is not in a virtuous war with government; the only victim in America is the ordinary worker. One only has to see the film Inside Job to see how government and the financial system have worked in tandem, in large part because it is the same people playing both sides of the fence.

Grantham puts it down to childishness in the political arena, run by a president he calls “President No-Show”. I think it is not just a matter of maturity, it is a deeper and more pernicious political contest. At the heart of it is a question about the proper role of self organisation. Democracy is, or should be, a self organising system. So are markets. That obviously has advantages over central planning, but it also has potential dangers. The shortcomings are especially problematic in the case of financial markets, which are by necessity a system of rules. Allowing financiers to self organise the rules, means that they can do exactly what has happened — go a long way to destroying the system while enriching themselves to an absurd extent.

Thus they made up rules for everything: credit default swaps, collateralised debt obligations, derivatives on the weather, high frequency trading, more high frequency trading … you name it. Allowing that kind of self organisation is fundamentally absurd because in the end such invention of new rules rely for their validity on the underlying rules that must be set by governments and regulators (The Fed’s interest rate, the underlying cost of money, being the basic one). So when it is allowed to spin out of control, it will inevitably bring the whole system down, as it still threatens to do. Allowed to run amok, it becomes like the serpent that consumes itself.

Which is why the Icelandic example is interesting. The people, then the government, self organised and simply said: we don’t accept the bankers’ rules. “Why should they?” one might reasonably ask.

The Icelandic move is where we are heading. The rule makers in the financial system, who think they can make up rules as they go, are on a collision course with those who have to assent to the rules — the people and the governments they appoint. So far, it is mostly presented as a management problem — how can governments manage their fiscal and monetary levers — but it will become more than that. It will become a question about who has the right to set rules and possess power.

The outcome is not a foregone conclusion, even in democracies. Grantham argues that there needs to be more income distribution, a reversal of the money grab of the rich in the United States, in order to return to a more balanced form of economic growth. But that is by no means inevitable, indeed it is not even the norm. More normal is what happened in South America in the 60s, 70s and 80s where the middle classes were gutted and the rich ruled with increasing violence. As Grantham shows, America is heading the same way — its middle class has been progressively eviscerated for about 40 years, while corporations and the rich have thrived. The history of human behaviour tells us that, unless stopped, the powerful will enslave the weak and America is heading in that direction.

One thing that is needed is an understanding of the right place for self organisation and the wrong place for self organisation. The looters in London did some marvellous self organisation, pursued their liberty to smash windows. Did that make it right? Those who cleaned up the mess also did some marvellous self organisation.

The degree of self organisation does not tell us nearly enough. We need to look at how to set the frameworks in which self organisation occurs; after all there must be frameworks if it is not to be mere chaos. The role of civil society which fed such actions as the London clean up needs to be revisited. The downgrading, or monetisation, of civil society has been one more unfortunate consequences of four decades of market worship. And it is time to see slogans like “liberty”, “freedom”, nonsense about the “invisible hand” as the sleight of hand that they are. Such slogans may have made some sense during the Cold War, but that was last century. A seminal political contest is occurring and there needs to be a new understanding of the role of self organisation (not least because industrial self organisation along industrial-era lines will not be sufficient to deal with the problems of pollution that the world faces, they will make them much worse).

It also means, by the way, abolishing the so called discipline of economics. Disqualifying it on the grounds of its dismal history of spewing out self serving, circular arguments that have led us to assume that transactions come first and humans second, and that the civic and legal bases on which modern democratic societies depend are inevitable, a force of nature, and can be abused at will.

Hope you enjoy this chat. I’m pretty sure I corrected saying “House” rather than “Senate” at the time but that appeared not to have made the edits. The peril of this medium is low/no tolerance for flubs.

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

What if all the world’s inside of your head
Just creations of your own?
Your devils and your gods
All the living and the dead
And you’re really all alone?
You can live in this illusion
You can choose to believe
You keep looking but you can’t find the woods
While you’re hiding in the trees
– Nine Inch Nails, Right Where it Belongs

Modern economics purports to be scientific. It is this that lends its practitioners ears all over the world; from the media, from policymakers and from the general public. Yet, at its very heart we find concepts that, having been carried over almost directly from the Christian tradition, are inherently theological. And these concepts have, in a sense, become congealed into an unquestionable dogma.

We’ve all heard it before of course: isn’t neoclassical economics a religion of sorts? I’ve argued here in the past that neoclassical economics is indeed a sort of moral system. But what if there are theological motifs right at the heart of contemporary economic theory? What does this say about its validity and what might this mean in relation to the social status of its practitioners?

Let us turn first to one of the most unusual and oft-cited pieces of contemporary economic doctrine: rational expectations theory.

Rational Expectations: Irrationality and an Encounter with the Godhead

Rational expectations is indeed an obscure doctrine. It essentially holds that people operating within a market generally act in line with the expectations of neoclassical theory. This tautology – for it is a tautology – can be traced back to Adam Smith’s ‘invisible hand’ which we explore in more detail later on.

But this goes beyond simple tautology. The neoclassical assumptions are themselves especially stringent and seem to be wholly counterfactual to any observer of human behaviour. Rational expectations theory expects people to act, well, rationally. More specifically it assumes that people always act in order to ‘maximise their utility’ and that such actions result in optimal behaviours that ensure that prices are always perfectly in keeping with what they ‘should be’ – that is, an equilibrium price that perfectly balances supply and demand. Prices then become a pristine and perfect measurement; they translate consumer desire perfectly and are beyond question.

Utility maximisation is a strange doctrine that goes right to the heart of rational expectations theory. It assumes that a fixed value can be placed on the satisfaction people derive from the things they buy. It also assumes – implicitly – that people are in some sense aware of this value and that they undertake their actions rationally in accordance with their perception of it.

At a glance this seems outlandish. Take consumption as the most glaring example. Anyone who has ever encountered any sort of marketing knows well that people don’t act in a perfectly rational manner. People often consume in line with what they perceive to be group expectations. Marketers and corporations take advantage of this and use it as leverage to jack up prices on certain goods. For example, are my brand name jeans really worth that much more in tangible terms than a non-brand names pair of jeans? I would say not.

Economists might counter this by arguing that consumers are still acting rationally insofar as their responding to marketers and brand names helps them further their social esteem: it gives them ‘social capital’ and it is this that the marketer is selling. To argue this is to fundamentally misunderstand the psychology of the consumer. The consumer may indeed identify with the group through the consumption of the product, however this is a deeply emotive act – not one in which the consumer cynically calculates that the product might enhance his or her ‘social capital’. It is not a rational response to the ‘social mores’ that the marketer is selling but rather an irrational response triggered by certain stimuli.

Marketers have understood this for nearly a century. Consider the case of a Lynx ad run a few years ago during the World Cup (here is the ad) – note also that Lynx have been running similar ads for years (which presumably means that this campaign has proved so effective that they have no need to fundamentally change it).

There is a certain amount of group identification present in this ad certainly (doesn’t every guy want to be the Don Juan who ‘scores’ all the chicks?), but there is definitely a deeper strata operating here. I don’t think I need to even point this out. The ad says it quite explicitly: ‘Spray more, get more’. This means that not only will you ‘get more’ women if you use Lynx, but also that if you literally spray on more Lynx you will literally get more women – a fantastic assertion.

Look again at the ad. Note how the guy is using an awful lot of Lynx. Indeed, it almost appears as if more women appear as he sprays on more of the deodorant (if one were to be terribly cynical one might read his end reaction in the ad as a sexual climax induced by his extremely liberal use of the deodorant). Anyone who has stood at a bar in a nightclub next to a guy smelling extremely heavily of Lynx will not doubt that this campaign has been at least somewhat effective.

The idea – a classic in marketing – is that not only to tie the consumer to the brand through group identification and the promise of sexual fulfilment, but to actually influence how the consumer uses the product itself. This ensures that the consumer will purchase more of the product because they will consume it faster. To claim that this behaviour is somehow rational is to pervert the English language itself. This behaviour is strongly irrational and those that attempt to manipulate it know this better than perhaps anyone else.

While we won’t go too far into the argument here, these observations can safely be transferred to most of the decisions that people make in all of the spheres dealt with by rational expectations theory. From direct investment to the purchase of stock to so-called inflation expectations, all have a strongly irrational aspect that is often manipulated by institutions for political and economic ends (the amount of institutions attempting to manipulate inflation expectations at the moment is quite incredible).

One example might be that of housing. During the boom years people invested money in housing not just because they might see a profitable return, but also because it became fashionable to own property – while the following clip is from a comedy show, the social observation is a sound one as far as Irish society during the property bubble is concerned. The boom rested not simply on the fact that it became ‘cool’ to own a house (this would be the social identification element as identified in the above clip), but also because being a homeowner has certain emotive overtones (having a family, being free from one’s parents etc.). These social expectations and emotive responses are key components not only in all speculative bubbles, but in all so-called market activity.

The fundamental point here is that people – be they consumers or producers, investors or forecasters – often act in an almost wholly irrational manner; one that is quite open to manipulation. And once we allow for this the very premise upon which rational expectations theory rests upon falls to pieces.

This is all very interesting, but it has nothing to do with theology, surely. Well, it is in the next key tenet of rational expectations theory that we truly encounter the Godhead.

Rational expectations theory assumes that people always operate on a complete amount of information. Economists call this ‘forecasting’ – although they might call it ‘crystal-ball gazing’. They do not assume that all consumers forecast perfectly at all time. However, they do assume that when any forecasting errors are made they are simply anomalies. This paper sums it up quite nicely:

The hypothesis of rational expectations means that economic agents forecast in such a way as to minimize forecast errors, subject to the information and decision—making constraints that confront them. It does not mean they make no forecast errors; it simply means that such errors have no serial correlation, no systematic component.

The idea here is that all economic actors have access to almost perfect knowledge of economic variables over time (prices, inflation etc.). True the above author qualifies that such forecasting is ‘subject to information and decision’** – which is more than many other economists allow – but this is a smokescreen. If we assume that market actors do not make mistakes in a given market then they must, by default, have access to almost perfect knowledge of that market; otherwise, to say that they don’t make mistakes is silly. If they were to have incomplete information then they would have to act, at least to some extent, on their gut instinct and so would, by definition, not be acting wholly rationally.

In rational expectations theory when market actors get market variables incorrect or act in an ‘incorrect’ manner on these variables this error is not taken to be indicative of some underlying uncertainty in their action, but simply an anomaly; an exception to the rule. Economic actors are assumed to have access to near perfect information, not just about the present but about the past and future as well.

Scratch a little deeper and you’ll find that this is an even more incredible assertion than it first appears. Rational expectations theory essentially assumes that consumers are omniscient beings – or at least, when they are acting ‘normally’ they are omniscient. This is where we encounter truly theological motifs in the edifice of neoclassical economics.

In many theologies, God is assumed to have perfect knowledge. And in order to gain access to this knowledge one needs only to try to build one’s relationship to God onto a higher plateau. In rational expectations it is assumed that individuals can indeed make mistakes – in theological terms: they can Sin – but these mistakes are never systemic – in theological terms: individuals are always on the way toward Salvation. As long as the individual keeps with the ‘tenets’ of the theory (which is presupposed), Sin is minimised and the individuals acts in line with the being possessing perfect knowledge.

The being of perfect knowledge is here not thought of as ‘God’ per se, but instead is given the name ‘The Market’. On a purely intellectual level the ideas seem almost identical. Both are overarching principles governing our lives, both are generally ‘followed’ unless perverse deviations (Sinners) crop up and both are perfect information processors.

We will return to this when we pick up Smith’s theory of the ‘invisible hand’ – a theory from which this all stems. For now let us turn to the true neoclassical Godhead: the efficient markets hypothesis.

The Efficient Markets Hypothesis: The Godhead Embodied

As we shall see shortly, ‘the Market’ is and always was a strongly theological idea. However, it is in the efficient markets hypothesis where the Godhead is truly to be located today.

Whereas the rational expectations model of the economic actor assumes that he or she is always in some sort of relationship with a being of perfect knowledge, the efficient markets hypothesis points the way to this divine being itself.

To really boil it down, the efficient markets hypothesis essentially states that all information is always already built into markets and hence they operate perfectly in line with how neoclassical theory would expect them to operate (i.e. with supply and demand in perfect equilibrium and prices reflecting this perfectly). In a way, the efficient markets hypothesis assumes that markets are made up of the actors we previously encountered in the rational expectations model. Since, as we have already seen, these actors always act in a predictable way, a conglomeration of them will process information perfectly.

The question to be asked is of the ‘chicken and egg’ variety: do these theories begin with the rational actor and then build upon this to form the efficient markets theory OR do these theories begin with the assumption of an overarching arena of rationality which is called ‘the market’ and then assume peoples’ actions based on this abstraction?

I would argue that the latter is the case. As we shall later see, if we trace these ideas right back to their roots we find that the theory of markets is far more primal than the theory of the rational individual – the latter is, in many ways, derived from the former.

So what status does this give the being that we call ‘the Market’? Well, if it is a being that is presupposed to exist while only being seen through its effects and is given the power to direct the behaviour of individuals, then it is surely of the theological variety. It is the Godhead embodied.
Many commentators – including this blog’s editor Yves Smith in her book ECONNED – have pointed out that the efficient markets hypothesis was used by policymakers to justify their cutting back on regulations and allowing ‘the Market’ to operate without constraint. These commentators have pointed out that it was this policy prescription that led to the current financial crisis.

It is also to be pointed out that these prescriptions were always undertaken with a kind of faith. Past experiences had cast into doubt that financial markets operated in line with the efficient markets hypothesis and yet those who pushed for deregulation were true believers in the hypothesis; they acted as if they were in a sort of irrational reverie, a suspension of historical remembrance wholly driven by their beliefs. It should not be surprising then that we find this idea to be a very close approximation of certain religious ideas and ideals.

The idea that there might be some overarching being – whether called ‘God’ or ‘the Market’ – that is directing all our activity and through whom we can be sure our actions are just and righteous, is a very attractive one. Like the religious ideas of yore it can both justify our actions when they are ethically questionable – we can assure people that such actions are in keeping with the Market’s Divine Will – and can assure us that the actions we undertake are reflected in and through some higher ideal – in this case a perfectly rational being we call ‘the Market’.

These ideals can also justify our actions after the fact when the God, so to speak, has failed. When this occurs – as has certainly happened today – devotees can assure the general public and their colleagues that it was simply a glitch, perhaps a testing of our faith and that we should never question the Market’s Will. Some of the more extreme devotees might even suggest that we have Sinned too greatly and that we have not followed the Market’s Will adequately enough. More deregulation is needed otherwise we might incur further punishment from the Divine Wrath.

Lying behind rational expectations theory and the efficient markets hypothesis is Adam Smith’s old notion of the ‘invisible hand’ and it is to this we now turn.

The Invisible Hand and Predestination

For by grace you have been saved through faith, and that not of yourselves; it is the gift of God, not of works, lest anyone should boast. For we are His workmanship, created in Christ Jesus for good works, which God prepared beforehand that we should walk in them – Ephesians 2:8-10

It was on this passage of the bible that the famous Protestant theologian Martin Luther based his idea that human beings had no free will. They were always subjects of God, bound up with Him and merely danced to whatever tune he played. This is the essence of the Protestant idea of Predestination. God has a plan for each and every one of us and we are just cogs in his great harmonious machine. It is His invisible hand that controls our actions and our destinies.

The importance of the invisible hand in the work of the first modern economist Adam Smith is hotly debated, since he used the metaphor only three times in his whole work and even then he used it only loosely. However, it is thought by many – and rightly, I think – as distilling the main thrust of his work in a single, useful phrase.

For Smith, the Market should be free to largely act autonomously. It ironed out its own inconsistencies and operated effectively and harmoniously. But what place did this leave for the individual?

Many today claim that Smith was the great prophet of human freedom. Yet if his theories are read as being wholly deterministic this surely cannot be the case. If the Market acts autonomously, unconsciously dictating all our actions then is there really space for liberty in classical or neoclassical economic theory? I would argue not.

The invisible hand permeates all aspects of neoclassicism. In a seminal paper entitled ‘Situational Determinism in Economics’ the philosopher of science Spiro Latsis shows that the whole neoclassical research program relies on an overarching determinism which he refers to as ‘situational determinism’. What he means by this is that, given a certain situation that a particular individual might find him or herself in, they will always necessarily choose one path – their behaviour will always follows a certain given direction.

This is, of course, the invisible hand at work. The person is directed or guided by an invisible force that leads them to undertake one action and avoid another. This should also be recognised as one of the fundamental aspects of rational expectations theory as outlined above: the individual is assumed to always act in a specific way and any other actions are thought to be ‘deviations’.

The invisible hand is truly the hidden thread tying together all sorts of neoclassical theories – from rational expectations to the efficient markets hypothesis. And in this it is simply a reiteration, in quote-unquote ‘secular’ form, of an age old Protestant theological assertion. What we get is a view of a world governed and controlled by a mystical and invisible force that sorts everything out for us. Everything operates without human governance, the world adheres to a set of laws handed down by an invisible agency; everything in its right place. This is Predestination pure and simple.
(It should be noticed that Austrian School ideologue Ludwig von Mises recognised that the invisible hand in Smith was in fact an image of God. He held, however, that secular reasoning led in this direction and did not see a problem with this. One can only assert that von Mises was more self-aware than other believers. See: note 3 on page 147 of Mises’ ‘Human Action’ – an ironic title given the thrust of our present discussion).

In modern neoclassical theory we find this structure operating mainly through the two theoretical postulates discussed in the first and second parts of this piece.

The efficient markets hypothesis postulates that there is an overarching and invisible force that cannot err. This is an image of a God controlling the world and ensuring that order emerges automatically out of chaos. All of us individuals are then conceptualised as living inside of this holy sphere. This leads to the assumptions of rational expectations theory.

In rational expectations theory, individuals are taken to act in the way assumed by neoclassical economics: that is, they rationally seek to maximise their gain in a particular way etc. The theory allows that they sometimes make mistakes, but these are thought of as ‘deviations’ and are never allowed be the norm. The Market, being infallible, omnipotent and unable to err, effectively ensures that individuals are not allowed to make mistakes in any systematic way. To cast this in theological language: God, being infallible, omnipotent and unable to err ensures that individuals are not able to Sin in any systematic way. While Sinning does take place, the overall thrust is for Man to follow the path that God has laid out for him.

The neoclassical paradigm offers its adherents a very attractive theology. It allows them to look at the world through a remarkably powerful set of rose-tinted glasses. It assures them that everything is okay – provided regulators and Sinners don’t get into positions of power – and that order and harmony will be established by an over-arching, quasi-external power. It gives its adherents a being that they can, in a very real sense, worship. It gives them a moral code that they can follow and that they can use to justify their actions, even when these appear to an external observer as being disgusting, idiotic and objectionable.

Dogmatism and Its Dangers

Perhaps this last point is the key one. The most dangerous personality trait of dogmatic religious devotees is their ability to insist that their extreme views are pure truth and that any action they undertake, no matter how destructive and stupid, are always already sanctioned by a higher power.

In his modernist classic ‘Ulysses’, there is a beautiful sentence in which James Joyce sums up the hypocrisy of religious dogmatists who use their fixed beliefs to justify actions that they might not be able to otherwise undertake in good conscience. Speaking of Oliver Cromwell’s brutal military campaign in Ireland in the mid-seventeenth century Joyce writes:

What about sanctimonious Cromwell and his ironsides that put the women and children of Drogheda to the sword with the bible text ‘God is love’ pasted round the mouth of his cannon?

What about him indeed? Such is the epitaph we might one day see on the tombstone of that strange secular religion that is neoclassical economics – although rather than the text ‘God is love’ pasted round the mouth of its collective cannon, there are instead written the words ‘the Market is always right’.

** As we will soon see, the meaning of the word ‘decision’ here is very shaky. How can a deterministic theory which claims to know how people will act allow them to have the power to make a decision? If they have the power to make a decision then, by default, this decision will be uncertain and no overarching theory will be able to capture it. By making reasonable qualifications to accompany an unreasonable theory the above author unwittingly destroys the theory itself.

Lordie, I can’t believe someone who professes to understand markets has written, at length, that caution, no, “excess of overcaution,” was a major contributor to the criss. Or has Felix Salmon been spending too much time with lobbyists from ISDA and SIFMA?

I hate seeming rude, but Felix has a habit of tearing into Gretchen Morgenson for errors much less significant than the one he made in a post today. He wrote, apropos this chart, which comes from FT Alphaville:

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage….

Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.

Now anyone who had read the Financial Times in 2006-early 2007 or was in the credit markets then would know that this statement, “it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution” is demonstrably counterfactual. All you had to do was look at the spreads for risky assets. There was a simply astonishing compression between the yields of perceived-to-be-risk-free assets, such as Treasuries and their toxic counterfeits, the AAA rated tranches of CDOs and CLOs, and risky assets, like the lower-rated tranches of the same bonds, as well as junk bonds. If there was “overcaution” you would have seen a wide spread between AAA bonds and lesser-rated bonds.

But to Felix’s point, demand for AAA paper was robust. But that was not the result of caution; two big drivers of demand (particularly for “manufactured” AAA paper, the kind created by structured credit legerdemain, was as repo to serve as collateral for OTC derivatives positions, and for bonus gaming. In the 1980s, the ONLY acceptable collateral for repo was Treasuries; that started expanding as time went on to other AAA rated assets (and even lower rated assets, but the haircuts were significant). We described both in ECONNED. First on the explosion of OTC derivatives stoked demand for AAA instruments:

Brokers and traders often need to post collateral for derivatives as a way of assuring performance on derivatives contracts…

Due to the strength of this demand, as early as 2001, there was evidence of a shortage of collateral. The Bank for International Settlements warned that the scarcity was likely to result in “appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

That is code for “dealers will probably start accepting lower-quality collateral for repos.” And they did, with that collateral including complex securitized products that banks were obligingly creating.

As time went on, repos grew much faster than the economy overall. While there are no official figures on the size of the market, repos by primary dealers, the banks and securities firms that can bid for Treasury securities at auctions, rose from roughly $1.8 trillion in 1996 to $7 trillion in 2008. Experts estimate that adding in repos by other financial firms would increase the total to $10 trillion, although that somewhat exaggerates the amount of credit extended through this mechanism, since repos and reverse repos may be double counted. The assets of the traditional regulated deposit-taking U.S. banks are also roughly $10 trillion, and there is also double counting in that total (financial firms lend to each other).

In other words, this largely unregulated credit market was becoming nearly as important a funding source as traditional banking.21 By 2004, it had become the largest market in the world, surpassing the bond, equity, and foreign exchange markets.

Now I must confess I have not tried to update the BIS chart. But I have a sneaking suspicion that while derivatives outstandings took a hit in the crisis, between a rise in risk aversion and a concerted effort in credit default swaps land to reduce the notional amount outstanding by netting out offsetting positions, that the old pattern of derivatives outstanding growing more rapidly than the economy has resumed. And now that no one is terribly interested in using AAA rated CDOs as collateral for repo, Treasuries are probably even more important as repo collateral than they were before the meltdown.

A second, significant demand for AAA rated paper was structured credit product creators uncharacteristically eating their own cooking because it enabled them to game their firms’ bonus systems. If you hedged an AAA instrument with a credit default swap from a high rated counterparty, Basel II allowed firms to treat it as having no capital requirement (and there was considerable latitude in the rules as to how much or little hedging was necessary to achieve this happy outcome). US banks in theory had analogous capital weightings, but their higher funding costs for this sort of activity and less permissive treatment of the hedges meant they didn’t do this sort of trade in anywhere near the same volume (save at Merrill, which engaged in accounting chicanery).

The net effect of these so-called negative basis trades were to allow the trading desks to credit FUTURE income (often years into the future), namely, the yield on the instrument less the funging and hedge costs, discounted to the present and was credited to the desk’s P&L. Nothin’ like getting paid on income never to be earned.

Now how significant was this activity? Again, from ECONNED:

J.P. Morgan estimated that Merrill and other major CDO vendors like Citigroup, UBS, and Deutsche Bank wound up keeping roughly two-thirds of the top-rated tranches of the 2006 and 2007 deals, which accounted for the bulk of the value of a transaction, typically 65% to 80%.

Read that again. 2/3 of the AAA CDO tranches were retained by the issuers. These were most assuredly NOT “overcautious”. Has s Felix forgotten some of the pre-crisis dismissals of caution, like US investment banks hoovering up subprime originators and servicers in late 2006 and early 2007? Or how about former Citigroup CEO Chuck Prince’s famously ill-timed expression of optimism in a Financial Times, right before the crisis began in earnest (early July 2007):

Chuck Prince on Monday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, saying Citigroup was “still dancing”.

The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

It’s alarming that someone like Felix, who not merely lived through the crisis but also chronicled it in some detail, seems so keen to engage in revisionist history.

I hate to seem to be beating up on Brad DeLong. Seriously.

As I’ve said before, he is one of the few economists willing to admit error and not try later to minimize or recant his admission (unlike, say, Greenspan). And he seems genuinely perplexed and remorseful. This puts his heads and shoulders above a lot of his colleagues, at least the sort whose opinion carries weight in policy circles.

Even with DeLong making an earnest effort to figure out why he went wrong, his latest musings, via a Bloomberg op-ed, “Sorrow and Pity of Another Liquidity Trap,” show how hard it is for economist to unlearn what they think they know. And as the great philosopher Will Rogers warned us, “It’s not what you know that gets you in trouble. It’s what you know that ain’t so.”

So it’s important to regard DeLong as an unusually candid mainstream economist, and treat his exposition as reasonably representative if you could somehow get his peers to take a hard, jaundiced look at how wrong they have been of late.

DeLong’s mea culpa is about how he and his colleagues refused to take the idea that the US could fall into a liquidity trap seriously. As an aside, this is already a troubling admission, since many observers, including yours truly, though the Fed was in danger of creating precisely that sort of problem if if dropped the Fed funds rate below 2%. It would leave itself no wriggle room if the crisis continued and it had to lower rates further into the territory where further reductions would not motivate changes in behavior. That’s assuming we were in a “normal” environment. But the big abnormality is that we are in what Richard Koo calls a balance sheet recession. And as we will discuss below, Keynes (and Minsky) had a very keen appreciation of the resulting behavior changes, but those ideas were abandoned by Keynesians (it is key to remember that Keynesianism contains significant distortions and omissions from Keynes’ thinking.

But notice how he starts his piece:

There is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down…

We’re on target to have $10.7 trillion outstanding by mid- 2012 — doubling the Treasury debt held by the public in just four years. Supply and demand tells us that a steep rise in Treasury borrowings should produce a commensurate fall in Treasury bond prices and thus higher interest rates — and that increase should crowd out other forms of interest-sensitive spending, slowing productivity growth…

Eventually the market’s appetite for Treasury bonds at high prices and low interest rates had to reach its limit, right? Supply and demand isn’t just a good idea — it’s the law.

No, it’s NOT the law, it’s a belief and it often is not operative. I would have liked to give it longer-form treatment in ECONNED, but the discussion there should suffice for our purposes:

But it is actually difficult to prove anything conclusively in economics. In fact, some fundamental constructs are taken on what amounts to faith. Consider the most basic image in economics: a chart with a downward sloping demand curve and the upward sloping supply curve, the same sort found in Krugman’s diagram. Deidre McCloskey points out that the statistical attempts to prove the relationship have had mixed results. That is actually not surprising, since one can think of lower prices leading to more purchases (the obvious example of sales) but also higher prices leading to more demand. Price can be seen as a proxy for quality. A price that looks suspiciously low can produce a “something must be wrong with it” reaction. For instance, some luxury goods dealers, such as jewelers, have sometimes been able to move inventory that was not selling by increasing prices. Elevated prices may also elicit purchases when the customer expects them to rise even further. Recall that some people who bought houses near the peak felt they had to do so then or risk being priced out of the market. Some airline companies locked in the high oil prices of early 2008 fearing further price rises.

The theoretical proof is also more limited than the simplified picture suggests. Demand curves are generally downward sloping, but in particular cases or regions, per the examples above, they may not be. Yet how often do you see a caveat added to models that use a simple declining line to represent the demand functions? Not only is it absent from popular presentations, it is seldom found in policy papers or in blogs written by and for economists. McCloskey argues that economists actually rely on introspection, thought experiments, case examples, and “the lore of the marketplace,” to support the supply/demand model.

DeLong then argues that he and presumably his colleagues ignored the notions of John Hicks, the English economist who formalized the idea of Keynes’ General Theory and turned it into a special case of neoclassical economics. Keynes himself repudiated it, as did Hicks in his eighties.

Why would Keynes not like this treatment? Keynes, himself a successful speculator, did not think financial markets had any propensity to equilibrium, and there is separately reason to think the equilibrium assumption that the discipline has embraced to make its mathematics “tractable” is bollocks. The equilibrium assumption (more accurately, ergodicity) makes it impossible to incorporate any phenomena that are destabilizing, such as ones with positive (self-reinforcing feedback loops. Yet as we discuss short form in ECONNED (and George Cooper gives an elegant layperson treatment in The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy), financial markets have no propensity to equilibrium. They are inherently prone to boom-bust cycles.

Even though Hicks’ story, via DeLong, bears some resemblance to Keynes’ liquidity preferences idea, it posits different causal channels that render them fundamentally different. In really simple terms, there is a “loanable funds” market in which borrowers and savers meet to determine the price of lending. Keynes argued that investors could have a change in liquidity preferences, which is econ-speak for they get freaked out and run for safe havens, which in his day was to pull it out of the banking system entirely. Hicks endeavored to show that the loanable funds and liquidity preferences theories were complementary, since he contended that Keynes ignored the bond market (loanable funds) while his predecessors ignored money markets.

But that’s a deliberate misreading. Keynes saw the driver as the change in the mood of capitalists; the shift in liquidity preferences was an effect. (In addition, Keynes held that changes with respect to existing portfolio positions, meaning stocks of held assets, would tend to swamp flow effects captured by loanable funds models.)

Making money cheaper is not going to make anyone want to take risk if they think the fundamental outlook is poor. Except for finance-intensive firms (which for the most part is limited to financial services industry incumbents), the cost of money is usually not the driver in business decisions, Market potential, the absolute level of commitment required, competitor dynamics and so on are what drive the decision; funding cost might be a brake. So the idea that making financing cheaper in and of itself is going to spur business activity is dubious, and it has been borne out in this crisis, where banks complain that the reason they are not lending is lack of demand from qualified borrowers. Surveys of small businesses, for instance, show that most have been pessimistic for quite some time.

If you want to put it in more technical terms, what is happening is a large and sustained fall in what Keynes called the marginal efficiency of capital. Companies are not reinvesting at a rate sufficient rate to sustain growth, let alone reduce unemployment. Rob Parenteau and I discussed the drivers of this phenomenon in a New York Times op-ed on the corporate savings glut last year: that managers and investors have short term incentives, and financial reform has done nothing to reverse them. Add to that that in a balance sheet recession, the private sector (both households and businesses) want to reduce debt, which is tantamount to saving. Lowering interest rates is not going to change that behavior. And if you try to generate inflation in this scenario, when individuals and companies are feeling stresses, all you do is reduce their real spending (and savings power) and further reduce demand (and hence economic activity).

If DeLong wanted to treat this issue in their conventional Hicks models, a shift down in the marginal efficiency of capital would be represented as a shift down and to the left of the IS schedule in interest rate/GDP space, not as changes in the slope of the LM schedule, which is what liquidity trap arguments focus on. Rob Parenteau has a very helpful discussion of the shortcomings of the Hicks model in “Employing Krugman’s Cross: Farewell, Mr. Hicks?”

Marshall Auerback, by e-mail, points out that liquidity trap thinking is based on the idea that banks lend out of bank reserves. It has been shown empirically that banks lend first and reserve creation follows (that is, when needed, central banks accommodate loan creation):

The liquidity trap idea seems to be predicated on the silly idea that banks lend out reserves and failure to do so is symptomatic of a liquidity trap. But idea that the build up of bank reserves represent a pot of funds that the banks will eventually loan out completely misunderstands the role of bank reserves. But as Randy Wray, Bill Mitchell, Scott Fullwiler, Stephanie Kelton and a host of others have noted before banks do not loan out reserves. Reserves facilitate the payments system – that is, the system that assures the millions of transactions between banks (as customers write cheques and deposit them throughout the banking system).

Banks do not make loans on the basis of the reserves they hold. They respond to demands from credit-worthy customers and have in mind what it will cost them to make the loans under current conditions. When the transactions that follow the creation of a loan transpire it might be that the is short of reserves to ensure the payments clear. It has various options. It can seek funds from wholesale markets (other banks or other lenders), use deposits (not an overnight option really) or, ultimately, it can source the funds from the central bank.

The point is that you can get various levels of bank reserves depending on how the central bank pursues its liquidity management in order to hit its target policy rate. None of those levels have any particular operational significance.

The mainstream then argue that if the central bank mops up these reserves it will be less inflationary than if it leaves them in the system. This view is based on the spurious – banks lend reserves argument. The inflation risk associated with government spending is the same whether the government issues debt to match its deficit or not. The inflation risk arises from the impact of the spending on the state of capacity in the economy.

This is why fiscal stimulus is vastly more effective than monetary policy at times like these: it has a direct impact on overall conditions, by stimulating demand. Government spending creates more income for businesses and ultimately, consumers. Everyone’s income is ultimately someone else’s spending. If government increase spending, it will increase the incomes of at least some people in the economy, and the improvement in their fortunes (if they believe the new income level will be sustained) will lead them to spend more, improving the affairs of yet more people.

But let’s take DeLong’s supply and demand theory at face value, since it isn’t inoperative, it is just not as neat, tidy, and iron-clad as he believes. DeLong seem to think that there is a discrete market for Treasuries (I’m exaggerating to make a point). But bonds are fungible. While there are some dedicated Treasury buyers, many investors will look at Treasuries as an alternative to other high quality bonds, depending on the yield and perceived risks. And many investors also shift their risk allocations, both from stocks to bonds, and within bonds, from risky to less risky bonds. We’ve seen a far more extreme version of this pattern of late, with a significant proportion of active investors switching from “risk on” to “risk off trades.

So why would investors want more Treasuries? First, in a deflationary environment, the place to be is cash, cash equivalents, and high quality bonds. Deflationary expectations would spike demand for Treasuries. Thus all the austerian policies at the state level alone, which is producing a substantial undertow, would boost demand for Treasuries.

But second, DeLong seems unaware of the fact that there has been a long-standing shortage of collateral for repo. Treasuries had once been the only acceptable collateral for repo. Again, from ECONNED:

Brokers and traders often need to post collateral for derivatives as a way of assuring performance on derivatives contracts…

Due to the strength of this demand, as early as 2001, there was evidence of a shortage of collateral. The Bank for International Settlements warned that the scarcity was likely to result in “appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

That is code for “dealers will probably start accepting lower-quality collateral for repos.” And they did, with that collateral including complex securitized products that banks were obligingly creating.

As time went on, repos grew much faster than the economy overall. While there are no official figures on the size of the market, repos by primary dealers, the banks and securities firms that can bid for Treasury securities at auctions, rose from roughly $1.8 trillion in 1996 to $7 trillion in 2008. Experts estimate that adding in repos by other financial firms would increase the total to $10 trillion, although that somewhat exaggerates the amount of credit extended through this mechanism, since repos and reverse repos may be double counted. The assets of the traditional regulated deposit-taking U.S. banks are also roughly $10 trillion, and there is also double counting in that total (financial firms lend to each other).

In other words, this largely unregulated credit market was becoming nearly as important a funding source as traditional banking.21 By 2004, it had become the largest market in the world, surpassing the bond, equity, and foreign exchange markets.

Now I must confess I have not tried to update the BIS chart. But I have a sneaking suspicion that while derivatives outstandings took a hit in the crisis, between a rise in risk aversion and a concerted effort in credit default swaps land to reduce the notional amount outstanding by netting out offsetting positions, that the old pattern of derivatives outstanding growing more rapidly than the economy has resumed. And now that no one is terribly interested in using AAA rated CDOs as collateral for repo, Treasuries are probably even more important as repo collateral than they were before the meltdown. I’d welcome informed reader input on these issues.

Mind you, it is not as if anything here is esoteric; in fact, it has been said by quite a few economists. It just seems to have no impact on the orthodoxy that dominates policy discussions, even for those like DeLong who recognize that the results of fealty to these ideas have been disastrous.

I though readers might welcome an antidote from the nonsense that bank industry touts like the Office of the Comptroller of the Currency’s John Walsh routinely puts forth.

I’ve known Amar Bhidé, who is now a professor at Tufts, for thirty years; we both worked on the Citibank account at McKinsey (although never on the same study). He’s long had a reputation for being incredibly smart and iconoclastic.

Amar enjoys annoying people by saying completely commonsensical things that are not acceptable and watching chaos ensue. The last occasion I witnessed first hand was at a dinner party with a lot of finance journalists and markets professionals in attendance. Amar matter of factly said Obama blew it by not having a one week bank holiday to get to the bottom of how bad a mess the biggest banks really were and making needed interventions (which presumably could include resolving them). Consternation ensued: virtually everyone save yours truly argued that there would be a revolution because people would not be able to access their money market funds (no, I am not making this up, this was pretty much the only objection voiced, but it was made with considerable energy).

Now there are some legitimate concerns to be raised about the Bhidé plan (what happens to the Eurodollar market? What happens if any banks have payments on bonds held by foreigners due during the week when they are shuttered? What if Citigroup’s foreign depositors freak out? Are you sure the government can resolve either Citi or Bank of America if they were deemed to be terminal?). But instead all this group did was effectively recoil and say, “No, you can’t do that. The world would come to an end.” This reaction was testament as to how successful the banks have been in conditioning the elites to act as their mouthpieces.

Bhidé also managed the neat trick in his recent book, A Call to Judgment, of annoying both the right and the left. He uses Hayek to argue that that banking industry has evolved in a way that leads to bad decisions and it now destroys value on a large scale. He calls for a return to what he depicts as “primitive banking” and it has a lot in common to the utility banking model we have discussed here. And Bhidé, who was briefly a proprietary trader and continues to be a successful investor, really means “primitive”. For instance, he thinks stocks should not be publicly traded; the only relationship that makes any sense for a legal promise as ambiguous as that of equity ownership is a venture capital/private equity relationship, where the investor knows the management of the company and is meaningfully involved in its affairs.

I suspect readers will enjoy this interview. Bhidé pretty much calls JP Morgan a criminal enterprise, although in context, he is merely citing that bank as typical of the industry. He also very clearly says CEOs are not in control of these enterprises and that the engage in activities that “can’t be managed, can’t be examined.” That of course begs the question of why these corporate chieftans are so well paid. We argued in ECONNED that the major capital market firms were engaged in looting and that top management was at best hostage to the producers (the business unit managers) and at worst, in cahoots. Bhidé’s gloss might strike some readers as unduly charitable. However, if the top brass is incapable of doing its job, that means the banking industry needs to be radically restructured.

The SEC announced that JP Morgan has agreed to pay $153.6 million to settle charges related to a $1.1 billion heavily synthetic CDO called Squared which JP Morgan placed in early 2007 and was managed by GSC Partners, a now defunct CDO manager. The SEC has a cute but not all that helpful visual on the site, save it reflects the role of Magnetar as the moving force behind the deal.

Per the SEC’s complaint against JP Morgan, Magnetar provided $8.9 million in equity and shorted $600 million notional, or more than half the face amount of the CDO (this is consistent with our analysis, which had suggested that Magnetar, unlike Paulson, did not take down the full short side of its deals, since it like staying cash flow positive on its investments. The size of its short position was limited by the cash to be thrown off by the equity tranche). And needless to say, this was a CDO squared, meaning a CDO made heavily of junior tranches of other CDOs, so it was a colossally bad deal.

The complaints (one against JP Morgan and the other against GSC employee Edward Steffelin) make clear that the SEC had gotten its hands on some pretty damning e-mails. The core of the allegation against JPM was that all the marketing materials represented that the assets in the CDO were selected by GSC when they were in fact to a significant degree chosen by Magnetar.

Magnetar made clear that it regarded its equity position as “basically nothing” and really wanted to “buy some protection”, meaning get short and that Magnetar was actively involved in choosing the exposures for the deal. And JP Morgan clearly understood Magnetar’s aims and the precariousness of the subprime market: “We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart. ” Per the complaint, Magnetar was involved in the selection process both by affirmatively recommending assets to be including in the portfolio and nixing others suggested by JP Morgan (one amusing e-mail from Magnetar called some securities selected by JPM as “just stupid”, by implication because they were not “decent shorts”. Needless to say, those particular instruments were not part of the final deal).

This is also the first time the SEC has sued a someone from the collateral manager, and that case is still open. The SEC complaint against Steffelin who was in charge of the team at GSC that selected the assets for Squared, alleges that he was looking to get a job with Magnetar and was thus particularly eager to do its bidding:

On January 5, 2007, the employee at Magnetar primarily responsible for the firm’s
participation in the Squared transaction (“Magnetar Employee”), sent his supervisor an electronic
mail message stating, “Steffelin wants to leave GSC and start a manager for us . . .” His
supervisor replied, “Perfect,” to which the Magnetar Employee responded, “I knew u’d like
that!!”….

On February 22, 2007, the Magnetar Employee sent his supervisor an electronic
mail message with the subject line “Gsc blowing up” and the text “Ed [Steffelin] eager to get
something going. We could get whole team and all deals.” The Magnetar Employee’s
supervisor sent a reply electronic mail message asking, “Why are they blowing up?” and the
Magnetar Employee explained “They’ve been having [a] big fight over comp[ensation]. Think [the head of GSC’s structured credit department] is going to split, rest of team not that happy at
how they’ll be treat[ed] if they stay. As u know, Ed [Steffelin] was already planning to leave.”

On February 26, 2007, the Magnetar Employee sent his supervisor by electronic
mail message another update, stating, “Just got off the phone w Ed [Steffelin] . . . Ed thinks
whole team can be lifted, will be able to take along 5 deals currently in warehouse, makes it cash
flow positive day 1.”

While Steffelin was in the end never hired by Magnetar (who needs a CDO manager when the CDO market is dead?) these conversations took place while the deal was being put together.

The settlement amount is proportionately lower than the $550 million Goldman paid to settle its notorious Abacus transaction, but that SEC settlement, although drawn narrowly, appeared to signal that the SEC was not going to pursue any other Abacus trades, when Abacus was a 25 transaction program. By contrast, although the Squared CDO transaction was pretty dreadful (the investors lost everything), it was the only Magnetar CDO sold by JP Morgan.

The settlement amount is roughly equal to the value of the mezzanine tranche ($150 million) which was sold to actual “cash” investors (parties who put up real money). And as we’ve suggested, they were real stuffees:

The Mezzanine Investors included a faith-based not-for-profit membership organization headquartered in Minneapolis, Minnesota (Thrivent Financial for Lutherans), a company that provides insurance and retirement products based in Topeka, Kansas (Security Benefit Corporation) and financial institutions located in East Asia (Tokyo Star Bank, Far Glory Life Insurance Company Ltd., Taiwan Life Insurance Company Ltd., and East Asia Asset Management Ltd.).

The super senior, worth $935 million, went to three JP Morgan asset backed securities conduits that issued commercial paper. It looks like one unit of JP Morgan effectively treated another as a stuffee. And recall that Len Blavatnik, the sixth richest man in the world, may have been one of the ultimate stuffees; he sued JP Morgan after losing $100 million on a $1 billion, a number that should be impossible in a money market fund that per his agreement with JPM was to be kept liquid and invested conservatively. His funds were over-invested in risky mortgage related instruments.

We’ve written repeatedly about the dubious role of CDO managers in ECONNED and on this blog. Our analysis of Magnetar deals shows that GSC managed five Magnetar deals. We hope the SEC is looking into the balance of them.

Our Tom Adams spoke about the settlement on BNN. You can view the segment here.

It has taken forever for the SEC to probe the workings the biggest sponsor of toxic CDOs and of course the agency is going after only one highly publicized doggy deal. Nevertheless, the SEC has finally decided to look at the less than arm’s length relationship between the hedge fund Magnetar, whose Constellation program played a central role in blowing up the subprime bubble, and its collateral manager, which in this case a Merrill affiliated firm called NIR. As we will discuss, collateral managers were critical because they effectively served as liability shields for the other participants.

Note that Magnetar does not appear to be the target; the Financial Times reports that the SEC is examining how the deal’s underwriter Merrill sold the deal and how it worked with NIR.

The very same CDO that is the focus of the SEC probe, Norma, was also the first to be noticed outside the comparatively small community involved in creating and buying these deals, in a Wall Street Journal story by Serena Ng and Carrick Mollencamp in late 2007. By the standards of CDOs, Magnetar’s were somewhat exotic, in that they were heavily synthetic. Most (but not all) of the assets were credit default swaps; about 20% of the deal’s asset were bonds, primarily BBB tranches of subprime bonds or the lower rated tranches (AA to BBB) of other “mezz” (for mezzanine, meaning made largely of lower rated bond tranches) CDOs.

Ng and Mollencamp did a second story about Magnetar, which discussed how it had launched a series of CDOs (by their tally, $30 billion) and had set the deals up to fail. We did a fuller treatment of Magnetar in our book ECONNED and broke the story of how the fund played a central role in pumping up demand for the very worst subprime mortgages in the toxic phase of the bubble

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money . . . I’d expect every bit as much as Paulson

The important part of this arrangement was that the equity funder put up 4-5% of the deal in a cash or hybrid CDO. Because this was the scarce part of the equation, and the riskiest exposure, this investor was the sponsor of the deal and gained control over its parameters. At a minimum, the equity investor had veto rights over the bond exposures chosen, and reports from various Magnetar deals indicate that in some cases it presented lists of bonds to go into the deal and/or set criteria (as in the bonds be particularly “spready” which also meant drecky). Since Magnetar was using its equity stake to make sure it would be able to establish a short position that was a multiple of its equity position, making it net short, its interest lay in using its influence to make sure the CDO had particularly bad exposures.

One of the keys to this arrangement was the role of collateral managers (also called “CDO managers”), which were often not independent even if billed as such (for instance, the Levin report includes Goldman pitch books for its really doggy CDOs have pitchbooks that stress the quality of the CDO manager, when internal e-mails show the firm favoring CDO managers who were expected to be compliant). Many were small free standing firms (the industry joke was “a couple of guys with a Bloomberg terminal”) who depended on investment bank warehouse lines (lines of credit) to stay in business. We’ve written often about the questionable role of the CDO manager, first in ECONNED, and repeatedly on the site. From ECONNED:

If credit defaults swaps were regulated, this would be insurance fraud on a massive scale….

Anyone involved in these transactions probably understood the implicit logic, even if no one acknowledged it. But there is a remarkable absence of anyone who could be pinned with liability. Magnetar officially had no legal relationship to these deals. The investment bank packager/structurer was off the hook as long as he made reasonable disclosure (and remember, the standards are much lower here than for instruments that fall in the SEC’s purview). The only party on whom liability could be pinned is the CDO manager, who does have a fiduciary responsibility to all investors, not just the sponsor. But the fact that the party who in theory had the most to lose, Magnetar, approved their investments, would seem to exculpate the CDO manager.

From a 2010 post by Tom Adams, “SEC/CDO Litigation: Why Aren’t the Collateral Managers Being Sued Too?“:

One issue that continues to puzzle us, in looking at the sudden furor about seemingly duplicitous dealings by investment banks in the real estate related CDO business, is that the focus thus far has been primarily on the investment banks that packaged and sold these toxic investments….

On the other hand, in the great majority of CDOs, the collateral manager was presented as an independent party whose role was to make sure that the CDO performed well…..Thus the CDO manager can also be argued to have defrauded investors to the extent it acted as a rubber stamp for the wishes of the sponsor, and/or simply served as a marketing device for the investment bank packaging and arranging the deal…

It is also hard to imagine that the collateral managers didn’t understand the intentions of CDO sponsors like Magnetar and Paulson who were using CDOs as a way to establish a short position more cheaply than they might have otherwise. If you look at our list of Magnetar deals, sorted by collateral manager, four firms, Harding Advisory, GBC Partners, Putnam Advisory, and NIBC Credit Management, worked on multiple transactions. How plausible is it that they had no idea of the sponsor’s true aims?

The Ng/Mollencamp story (in 2007, mind you) suggests that the CDO manager for Norma was simply a shield for Magnetar’s true intent:

In 2006, [former penny stock operator Corey] Ribotsky [who headed the Merrill affiliated CDO manager NIR] says Merrill came to NIR with a new proposition: One of the investment bank’s clients, a hedge fund, wanted to invest in the riskiest piece of a certain type of CDO. Merrill worked out a general structure for the vehicle. It asked NIR to manage it.

“It was already set up when it was presented to us,” Ribotsky says. “They interviewed a bunch of managers and selected our team.”

So with the outlines of a case set forth in the Wall Street Journal over three years ago and the role of CDO managers getting considerable attention here and in other venues, most notably Michael Lewis’ The Big Short, the Financial Times tells us the SEC has finally roused itself:

The Securities and Exchange Commission is investigating Merrill Lynch’s sale of a complex mortgage-related security it created for Magnetar, an Illinois hedge fund, and the collateral manager involved in the deal, according to people familiar with the matter.

The investigation is one of several SEC probes into banks that helped underwrite billions of dollars of collateralised debt obligations, securities comprised of mortgages or derivatives linked to them.

It also marks a broadening of the SEC’s investigation into the role of collateral managers, institutions that help select the assets included in CDOs.

NIR Capital Management, a Roslyn, New York firm run by Corey Ribotsky, served as manager for the security under scrutiny, a $1.5bn CDO known as Norma. Neither Mr Ribotsky nor his attorney returned calls seeking comment.

Regulators are looking at whether collateral managers, which are supposed to serve CDO investors’ interests, fulfilled their obligations…

Regulators are also looking into whether Merrill mispriced assets in the CDO, these people say. Bank of America, which acquired Merrill Lynch, declined to comment. The bank previously said it lost $900m on the Norma CDO.

Merrill got stuck with a lot of CDO inventory when the music stopped. Louise Story in the New York Times described how Merrill engaged in dubious accounting to hide how large its holdings were.

And even better….the SEC case piggybacks on a private action:

In 2009 Dutch bank Rabobank, which invested in Norma through a loan, sued Merrill in a New York state court, alleging the bank overvalued some assets by marking them at face value even though their market value had already deteriorated by 15 per cent…

According to Rabobank’s lawsuit, Merrill allegedly created Norma as a “tailor-made way to bet against the mortgage-backed securities market”. The suit said: “Merrill Lynch hand-picked a beholden collateral manager that was willing to ignore its fiduciary duties to Norma’s investors by selecting Norma’s collateral pool at Merrill Lynch’s behest rather than on the basis of the rigorous independent analysis.”

This is an indication of how asleep at the wheel the SEC has been. Normally, you expect regulators to launch investigations and develop cases and then have private claimants build on the groundwork they have laid, not the reverse.

Tom Adams and I have tried multiple times to get the attention of the SEC, with no success. Tom is an attorney and an industry expert, and there are virtually none who are willing to jeopardize their union card by helping develop litigation strategies and/or serve as an expert witness. We finally did get to someone in the SEC Compliance division but we were told Compliance and Enforcement don’t play well together, and the Compliance officer got nowhere with Enforcement.

It is one thing if the SEC had met with us and decided we would not add much to their team, but the lack of interest when there were very few people who had a seat at the table in the CDO business to begin with seems very short sighted. But as this post suggests, the SEC’s approach here seems to be to go after only the lowest-hanging fruit, and in a product area as complex as CDOs, that will yield very few targets.

Yves here. This post is certain to annoy some readers. Note that Kelton does not address under what circumstances it is desirable to have the government run a surplus versus a deficit, merely what the implications are. Bill MItchell is rather forceful on this matter:

The US press was awash with claims over the weekend that the US was “living beyond” its “means” and that “will not be viable for a whole lot longer”. One senior US central banker claimed that the way to resolve the sluggish growth was to increase interest rates to ensure people would save. Funny, the same person also wants fiscal policy to contract. Another fiscal contraction expansion zealot. Pity it only kills growth. Another commentator – chose, lazily – to be the mouthpiece for the conservative lobby and wrote a book review that focused on the scary and exploding public debt levels. Apparently, this public debt tells us that the US is living beyond its means. Well, when I look at the data I see around 16 per cent of available labour idle in the US and capacity utilisation rates that are still very low. That tells me that there is a lot of “means” available to be called into production to generate incomes and prosperity. A national government doesn’t really have any “means”. It needs to spend to get hold off the means (production resources). Given the idle labour and low capacity utilisation rates the government in the US is clearly not spending enough. The US is currently living well below its means. But the US government can always buy any “means” that are available for sale in US dollars and if there is insufficient demand for these resources emanating from the non-government sector then the US government can bring those idle “means” into productive use any time it chooses.

Spending equals income. Someone has to spend for incomes to exist. For incomes to grow there has to be growth in spending. There are three sources of spending growth in a macroeconomy – the external sector (if net exports are positive); the private domestic sector; and the government sector (if the budget is in deficit).

That is indisputable. Economic growth is defined in terms of production and production only occurs if there are goods and services being purchased. Firms do not produce to hold inventory. Firms may invest in response to their guesses about future sales. These guesses will be heavily influenced by current consumer actions.

So when you get commentators and high-level monetary officials arguing that growth comes from not spending you have to ask why anyone would listen to their views and why they are paid to express them. I don’t mind bloggers who do it for free saying what they like but when highly-paid and highly-visible express views that are not grounded in any economic theory that is comprehensible but nonetheless seek to influence the policy debate then I get angry.

One problem in the US is that these decisions are politicized due to a lack of consensus on national priorities and an unwillingness to admit that we need a significant change in economic policy. Even though the evidence is all around us that the economic paradigm of the last 30 years, of using rising consumer debt to substitute for rising worker wage levels, is tapped out, those at the top of the economic heap still benefit from reimplementing it even if it isn’t very successful and looks likely to end in tears very soon. As we wrote in ECONNED:

The situation we are in now echoes that of the Great Depression. Although scholars still debate its causes eighty years later, a persuasive view comes from MIT economics professor Peter Temin. Temin, in his Lessons from the Great Depression, first sets forth the prevailing explanations and explains why each falls short. He argues that the culprit was the impact of World War I on the gold standard.

Recall that starting roughly in the 1870s, major European economies increasingly adopted the gold standard, and a long period of prosperity resulted. The regime was suspended in the UK and the major European powers during the war. Afterward, they moved to restore it, sometimes at considerable cost (England, for instance, suffered a nasty downturn in the early 1920s). But the aftereffects of the war meant the Edwardian period framework was unworkable. The deflationary forces they set in motion could have been countered by countercyclical measures after the Great Crash. But that was impossible with the gold standard. Indeed, as Temin notes, “Holding the industrial economies to the goldstandard last was about the worst thing that could have been done.”

Now readers may have trouble with that comparison, particularly since the conventional wisdom is that our policy responses have been so much better than those of the early 1930s. But the key point here is that the institutional framework locked the major actors into a particular set of responses. They were not able to see other paths out because they conflicted with an architecture and a set of beliefs that had comported themselves well for a very long time. It’s hard to think outside a system you grew up with. And remember, the gold standard did not break down overnight; the process took more than a decade.

By Stephanie Kelton, Associate Professor of Economics at the University of Missouri-Kansas City, Research Scholar at The Levy Economics Institute and Director of Graduate Student Research at the Center for Full Employment and Price Stability. Cross posted from New Economics Perspectives.

Imagine two people sitting on opposite ends of a 15-foot teeter-totter. The laws of physics dictate that the seesaw will balance if the product of the first mass (w1) and its distance (d1) from the fulcrum (i.e. the balancing point) is equal to the product of the other mass (w2) and its distance (d2) from the fulcrum. Thus, the physicist can show that the teeter-totter will be in balance when the fulcrum is placed 6 feet from the end holding a 150lb person and 9 feet from the end holding a 100lb person. Moreover, the laws of physics ensure that an imbalance will arise if the mass or the relative position of one of the people is changed.

The laws of accounting allow us to demonstrate that similarly powerful concepts apply to the science of economics. Beginning with the simple identity for GDP in a closed economy, we have:

[1] Y = C + I + G, where:

Y = GDP = National Income
C = Aggregate Consumption Expenditure
I = Aggregate Investment Expenditure
G = Aggregate Government Expenditure

For economists, this is as obvious as stating that a linear foot is the sum of 12 sequential inches. It simply recognizes that the total amount of money spent buying newly produced goods and services will yield an equivalent income to the sellers of these products. Thus, it demonstrates that expenditures are a source of income.

Once earned, income can be allocated in one of three ways. At the end of the day, all income (Y) will be spent (C), saved (S) or used in payment of taxes (T):

[2] Y = C + S + T

Since they are equivalent expressions for Y, we can set equation [1] equal to equation [2], giving us:

C + I + G = C + S + T

Or, after canceling (C) from both sides and moving terms around:

[3] (S – I) = (G – T)

Equation [3] shows that there is a direct relationship between what’s happening in the private sector (S – I) and what’s happening in the public sector (G – T). But it is not the one that Pete Peterson, Erskin Bowles, or President Obama would have you believe. And I want you to understand why they are wrong.

To understand the argument, imagine that you and Uncle Sam are sitting on opposite ends of a teeter-totter. You represent the private sector, and your financial status is given by (S – I). Your budget can be in balance (S = I), in deficit (S < I) or in surplus (S > I). When your financial status is positive (S > I), you are net saving. When your financial status is negative (S < I), you are net borrowing. Uncle Sam’s financial status is equal to (G – T), and, like yours, his budget may be balanced (G = T), in deficit (G > T) or in surplus (G < T). When you interact, only three outcomes are possible.

First, it is conceivable that (S = I) and (G = T) so that (S – I) = 0 and (G – T) = 0. When this condition holds, the teeter-totter will level off with each of you experiencing a balanced budget.

In the above scenario, the government is balancing its receipts (T) and expenditures (G), and you are balancing your savings and investment spending. There is no net gain/loss.

But suppose the government begins to spend more than it collects in taxes (i.e. G > T). How will Uncle Sam’s deficit affect your position on the teeter-totter? The answer is as straightforward as increasing the mass of the person on the right-hand side of the seesaw. As Uncle Sam’s financial position turns negative, your financial position turns positive.

This should make intuitive as well as mathematical sense, because when Uncle Sam runs a deficit, you receive more financial assets than you lose through taxation. Put simply, Uncle Sam’s deficit lifts you into a surplus position. Moreover, bigger deficits mean bigger surpluses for you.

Finally, let’s see what happens when Uncle Sam tightens his belt. Suppose, for example, that we were able to duplicate the much-coveted surpluses of 1999-2001. What would (and did!) happen to the private sector’s financial position?

Because the economy’s financial flows are a closed system – every payment must come from somewhere and end up somewhere – one sector’s surplus is always the other sector’s deficit. As the government “tightens” its belt, it “lightens” its load on the teeter-totter, shifting the relative burden onto you.

This is not rocket science, but it appears to befuddle scores of educated people, including President Obama, who said, “small businesses and families are tightening their belts. Their government should, too.” This kind of rhetoric may temporarily boost his approval ratings, but the policy itself will undermine the efforts of the very families and small businesses that are trying to improve their financial positions.

* I’ll be back with a second installment that shows what happens when we ‘open’ the economy to take into account the foreign sector (and the relevant financial flows). Many of us have been working with financial balance equations for years (see here for references), so the current effort is nothing new. I am merely trying to make the arguments more accessible by changing the way they are presented.

UBS strategist George Magnus helped popularize economist Hyman Minsky’s thinking in the runup to the financial crisis by warning of the likelihood of a “Minsky moment.” For those not familiar with Minsky’s work, a short overview from ECONNED:

Hyman Minsky, an economist at Washington University, observed [that] periods of stability actually produce instability. Economic growth and low defaults lead to greater confidence and, with it, lax lending.

In early stages of the economic cycle, thanks to fresh memories of tough times and defaults, lenders are stringent. Most borrowers can pay interest and repay the loan balance (principal) when it comes due. But even in those times, some debtors are what Minsky calls “speculative units” who cannot repay principal. They need to borrow again when their current loan matures, which makes
them hostage to market conditions when they need to roll their obligation. Minsky created a third category, “Ponzi units,” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s observation:

Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in speculative and Ponzi finance.

What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy, meaning that

. . . speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.

Ouch.

From that, Magnus coined “Minsky moment” in early 2007, which occurs when

…lenders become increasingly cautious or restrictive, and when it isn’t only over-leveraged structures that encounter financing difficulties . . The risks of systemic economic contraction and asset depreciation become all too vivid.

Given that Magnus was one of the few prior to the financial meltdown (and not too long before either) to see the possibility of a generalized credit contraction, as opposed to, say, a “contained” subprime crisis, his warning on China is worth considering. He highlights, as other commentators have, that China’s dependence on investments, now 47% of GDP, is unprecedented, particularly in a large economy. In addition, half that total is in property investments, which is not necessarily productive.

But what troubles Magnus most about Chinese investment is the degree to which it depends on lending. From the Financial Times:

But a more immediate worry is the growing credit intensity of China’s economy. What China calls “total social financing” – conventional bank loans and most other external sources of finance – was still 38 per cent of GDP in the first quarter of 2011, almost as high as in 2009 when China implemented a credit-centric stimulus programme. The credit intensity of growth, or the amount of new credit generated for each unit of GDP growth, has risen from 1-1.3 before 2009 to 4.3 in 2011.

Despite a 500 basis points rise in bank reserve requirement ratios since January 2010, and four 25bp increases in interest rates since October, credit demand and supply seem barely affected. In real terms, interest rate levels are the lowest for 13 years: the three-month deposit rate stands at -3 per cent, and the one-year lending rate at 1 per cent. Companies are borrowing more as cash-flows weaken, with energy, utility and wage bills rising.

Although formal bank loan volumes are subject to restraint, they only comprise about half of TSF. Companies can also access plentiful liquidity in Hong Kong, where the renminbi deposit market has increased eightfold since mid-2010 to more than RMB400bn and where offshore renminbi financing is rising fast….

But financial instability, arising from excessive credit, increasing inflation and weak investment returns, is always an important catalyst…..In this, the leadership changeover in 2012, a reluctance to compromise growth or alienate workers, and political interests in rising property prices could lead to a premature call of victory over inflation. This might boost asset price and growth in the short term, but increase the likelihood the new leadership will have to deal with a credit-fuelled Minsky moment.

Magnus does depict another set of choices which would steer clear of that result, that of increasing interest rates both to stanch inflation and shift the economic model away from lending-stoked investment towards more consumption. But putting on the brakes will slow growth short term. This is a tricky bit of economic management, and as the experience in the US and other major economies in the 1970s and 1980s showed, politicians are reluctant to induce a recession (which is what it might take in China to shift gears) until the alternative is painful. And even then, the temptation is to abandon the course. Carter pressured Volcker to abandon his squeeze on financial firms and the economy generally; can you imagine either Greenspan or Bernanke showing Tall Paul’s resolve? Today’s nominally independent Fed chairmen have been pre-screened for their bankster friendliness.

Given that preventing labor unrest is a major priority in the Chinese officialdom, it seems they have a non-win situation: either see worker real incomes squeezed further by rising prices, or deprive some, perhaps many, of jobs by putting the brakes on growth. As much as the entire world has every reason to hope for a happy outcome, soft landings are notoriously hard to engineer even in a command economy like China’s.

As longstanding readers of this blog presumably know, we broke the story of Magnetar, a Chicago-based hedge fund. Magnetar was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money . . . I’d expect every bit as much as Paulson

The important part of this arrangement was that the equity funder put up 4-5% of the deal in a cash or hybrid CDO. Because this was the scarce part of the equation, and the riskiest exposure, this investor was the sponsor of the deal and gained control over its parameters. At a minimum, the equity investor had veto rights over the bond exposures chosen, and reports from various Magnetar deals indicate that in some cases it presented lists of bonds to go into the deal and/or set criteria (as in the bonds be particularly “spready” which also meant drecky). Since Magnetar was using its equity stake to make sure it would be able to establish a short position that was a multiple of its equity position, making it net short, its interest lay in using its influence to make sure the CDO had particularly bad exposures.

Even JP Morgan, which was less active in the CDO game than other major dealers, wound up working with Magnetar. The Financial Times discusses that the SEC is negotiating a settlement with JPM on a Magnetar CDO called Squared that lost 80% of its value. Note that Magnetar piously insists it did not select the bonds in this deal. Technically, that role fell to the CDO manager, but they were very responsive to the desires of equity sponsors, thus providing useful legal cover. But

From the Financial Times:

The SEC probe into JPMorgan is focused on whether the bank told investors that Magnetar, a hedge fund that bet against certain parts of the deal, helped select the portfolio.

JPMorgan ultimately lost $880m on the CDO, known as Squared, after the housing market collapsed.

Magnetar has not been accused of any wrongdoing.

Previously, a spokesman for Magnetar said the firm “did not select the assets for the Squared transaction or require that any specific assets be put into that transaction. Further, it did not originate the Squared transaction”. The firm also said it had been “transparent in its dealings with market participants”.

Note that CDOs were sold as exempt transactions without any SEC registration or involvement, which meant it provided even less protection to investors than mortgage-backed securities investors had. Before 1995 these offerings, which were private placements had to comply with Section 12 of the 1933 Securities Act:

Any person who…offers or sells a security …by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,…shall be liable … to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

This section would appear to impose liability for false and misleading statements and omissions in private placements just as in the case for public offerings. That was the view of securities lawyers up to the landmark 1995 Supreme Court decision, Gustaffson v. Alloyd. In Gustaffson, however, the Court ruled that offering documents in private placements were not prospectuses as defined under the 1933 Act which mean there was no liability attached under Section 12.

As a result, investors in a private placement could rely only on Rule 10b-5 to protect them from false and misleading statements or omissions. But the problem is that Rule 10b-5 is that investors not only have to prove that the disclosure was deficient, but also that the seller had the intent to defraud.

Proving intent is a much higher bar for prospective plaintiffs. The Gustaffson made it much more difficult for fleeced CDO investors to prevail.

And now you see why Magnetar continues to insist it was clean. Intent is hard to prove, and the hedge fund appears to have been particularly careful about its communications. But our contacts on dealer desks understood full well that the objective was to create deals that would crater.

I was already mundo unhappy with an Alan Greenspan op-ed in the Financial Times, which takes issue with Dodd Frank for ultimately one and only one disingenuous and boneheaded reason: interfering with the rent seeking of the financial sector is a Bad Idea. It might lead those wonderful financial firms to go overseas! US companies and investors might not be able to get their debt fix as regularly or in an many convenient colors and flavors as they’ve become accustomed to! But the Maestro managed to outdo himself in the category of tarting up the destructive behaviors of our new financial overlords.

What about those regulators? Never never can they keep up with those clever bankers. Greenspan airbrushes out the fact that he is the single person most responsible for the need for massive catch-up. Not only due was he actively hostile to supervision (and if you breed for incompetence, you are certain to get it), but he also gave banks a green light to go hog wild in derivatives land. And on top of that, he allowed banks to develop their own risk models and metrics, which also insured the regulators would not be able to oversee effectively (there would be a completely different attitude and level of understanding if the regulators had adopted the posture that they weren’t going to approve new products unless they understood them and could also model the exposures).

And the most important omission is that the we just had a global economic near-death experience thanks to the recklessness of the financial best and brightest. You’d never know that if you read the Greenspan piece, which merely argues against the idea of restricting financial activity under the guise of objecting to certain provisions of Dodd Frank.

I keep referring to this passage of a 2010 paper by Andrew Haldane, the Executive Director of Financial Stability for the Bank of England because Greenspan, the Administration, and other banking industry cheerleaders keep pretending that the crisis was a mere blip and their ongoing propagandizing needs to be countered:

Table 1 looks at the present value of output losses for the world and the UK assuming different fractions of the 2009 loss are permanent….

As Table 1 shows, these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

In other words, the financial system as it is presently constituted is so destructive to society at large that very radical interventions are warranted to reduce the costs it imposes on others. To put it another way, it is an extraordinarily inefficient at looting. And Haldane’s core observation, that severe financial crises result in permanent output losses (more colloquially, a permanent reduction in the standard of living) is not controversial. And I’ve recently corresponded with Haldane and he stands by this rough and ready estimate.

Yet as horrific as the Greenspan piece is, he manages to sink to unimaginable new lows with the Big Lie he offers at its close:

The vexing question confronting regulators is whether this rising share of finance has been a necessary condition of growth in the past half century, or coincidence. In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living.

In other words, the defective growth model of the last 30 years, one that rested on stagnant worker wages and relied on rising levels of debt which fueled bigger and bigger asset bubbles, is now presented as a virtue.

Consider this alternative formulation from ECONNED:

Let’s use a different metaphor to illustrate the problem. Say a biotech firm creates a wonder crop, the most amazing creation in the history of agriculture. It yields far more calories per acre than anything else, is nutritionally extremely complete, and can be planted and harvested with far less machinery and equipment than any other plant. It is tasty and can be prepared in a wide variety of ways. It is sweet too, so it can be used in place of sugar and high fructose corn syrup at lower cost. We’ll call this XCrop.

XCrop is added as a new element in the food pyramid and endorsed by nutritionists and public health officials all over the globe. It turns out that XCrop also is an aphrodisiac and a stimulant (hmm, wonder how they engineered that in) and between enhanced libido and more abundant food supplies, the world population rises at a faster rate.

Sales of XCrop boom, displacing traditional agriculture. A large amount of farmland is turned over from growing other types of produce to XCrop. XCrop is so efficient that agricultural land is taken out of production and turned to other uses, such as housing, malls, and parks. While some old-fashioned farms still exist, they are on a much smaller scale and a lot of the providers of equipment to traditional farms have gone out of business.

Twenty years into the widespread use of XCrop, doctors discover that diabetes and some peculiar new hormonal ailments are growing at an explosive rate. It turns out they are highly correlated with the level of XCrop consumption in an individual’s diet. Long-term consumption of high levels of XCrop interferes with the pituitary gland, which controls almost all the other endocrine glands in the body and the pancreas.

The public faces a health crisis and no way back. It would be very difficult and costly to put the repurposed farmland back into production. Some of the types of equipment needed for old-fashioned farming are no longer made. And with the population so much larger than before, you’d need even more farmland than before. The world population has become dependent on the calories produced by XCrop, so going off it quickly means starvation for some. But staying
on it is toxic too. And expecting users simply to restrain themselves will likely prove difficult. The aphrodisiac and stimulant effects of XCrop make it addictive.

Advanced economies have become hooked on debt technology, which, like XCrop, is habit forming and hard to wean oneself off of due to its lower cost and the fact that other approaches have fallen into partial disuse (for instance, use of FICO-based credit scoring has displaced evaluations that include an assessment of the borrower’s character and knowledge of the community, such as
stability of his employer). In fact, the current debt technology results in information loss, via disincentives to do a thorough job of borrower due diligence (why bother if you are reselling the paper?) and monitoring of the credit over the life of the loan. And the proposed fixes are not workable. The Obama proposal, that the originator retain 5% of the deal and take correspondingly lower fees, is not high enough to change behavior. And a level that would be high enough to make the originator feel the impact of a bad decision would undercut the cost efficiencies that made securitization popular in the first place. You’d have better decisions, but less lending, and higher interest rates. That’s ultimately a desirable outcome, but as in the XCrop situation, no one seems prepared to accept that a move to healthier practices will result in much more costly and less readily available debt. The authorities want to believe they can somehow have their cake and eat it too.

And in case you think this reading is a tad too downbeat, a very good piece in the National Journal by Michael Hirsh, The Resurrection, demonstrates not merely that perilous little has changed in the wake of the financial crisis, but that in many respects, the pathology has gotten even worse:

Government data indicate that lending abroad is up even as investment in plants and equipment at home continues to decline or remain flat as a percentage of GDP. FDIC-insured banks loaned nearly twice as much, $62.7 billion, to banks in other countries as of the end of 2010 as they did the year before…

Regulators in Washington, in Basel, Switzerland, and elsewhere have failed to agree on rules for the much-touted “resolution authority” in the new law. Theoretically, this rule is supposed to give the United States the right to liquidate or unwind a failing firm, no matter how big, without the systemic crash that nearly followed the Lehman bankruptcy of September 2008. The rule is still just a draft, however, and so far it doesn’t look very workable internationally.

That’s because countries are addressing the same issue in very different ways….Straddling all these fractured lines are Citi and the other big global banks. “Citibank is a $1.8 trillion company, in 171 countries with 550 clearance and settlement systems,” says one senior Federal Reserve Board regulator who would speak frankly only on condition of anonymity. “We think we’re going to effectively resolve that using Dodd-Frank? Good luck!”….Bove, a widely followed banking analyst on Wall Street, calls Dodd-Frank “the dumbest piece of legislation ever created by the U.S. Congress. They wanted the big banks to have less control, yet they built in rules that ensure the increased control of the financial sector by big banks…..“And there is nothing in Dodd-Frank that will do anything to stop a meltdown from occurring.”

We’ve been critical of the phony resolution authority as well as other features of Dodd Frank. But the reason is, as the critics Hirsh cites remind us, that the legislation failed to accomplish its stated aims and may be increasing big bank power.

Greenspan, by contrast, clearly object to the basic premise of Dodd Frank, that governments should have any meaningful say over the operation of financial financial firms. Einstein defined insanity as doing the same thing over and over again and expecting different results. But the true madness isn’t that Greenspan’s remarks border on deranged; he’s merely a useful and highly paid idiot. It’s that anything he says is still listened to after the huge cost his misguided policies have inflicted on all of us.